When you own a business, it's important to retain some of your earnings to reinvest into the business, pay down debt, give shareholders a return on their investment, or save for a rainy day. Retained earnings are the profits you retain in your business. It can also refer to the balance sheet account you use to track those earnings.
This article highlights what the term means, why it's important, and how to calculate retained earnings.
What is retained earnings?
Retained earnings are the profits that remain in your business after all costs have been paid and all distributions have been paid out to shareholders.
Retained earnings aren't the same as cash or your business bank account balance. Your cash balance rises and falls based on your cash inflows and outflows—the revenues you collect and the expenses you pay. But retained earnings are only impacted by your company's net income or loss and distributions paid out to shareholders.
On your company's balance sheet, they're part of equity—a measure of what the business is worth. They appear along with other forms of equity, such as owner's capital. If your business has lost money from year to year or has paid out more distributions to shareholders than you've earned in profit, your retained earnings account will have a negative balance, also known as retained losses.
Your financial statements may also include a statement of retained earnings. This financial statement details how your retained earnings account has changed over the accounting period, which may be a month, a quarter, or a year.
How to calculate retained earnings
To calculate retained earnings, you take the current retained earnings account balance, add the current period's net income (or subtract the net loss), and subtract any dividends or distributions to owners or shareholders.
In other words, the formula for calculating retained earnings is:
Current retained earnings + profit or loss – distributions or dividends = ending retained earnings
For example, let's say you went into business in 2021. Your retained earnings account is $0 because you have no prior period earnings to retain.
During 2021, you had a net income of $250,000 and pay distributions totaling $100,000 to you and your business partner. On Jan. 1, 2022, your company's retained earnings would be:
$0 + $250,000 - $100,000 = $150,000
If you use accounting software to track your company's revenues, expenses, and other transactions, the software will handle the calculation for you when it generates your financial statements.
Why are retained earnings important?
Retained earnings are important for a small business because they represent earnings that you can:
- Reinvest into the business for growth or expansion
- Pay off debts
- Save for the future
You may also distribute retained earnings to owners or shareholders of the company. Companies that pay out retained earnings in the form of dividends may be attractive to investors, but paying dividends can also limit your company's growth. That's why many high-growth startups don't pay dividends—they reinvest them back into growing the business.
Investors often look at a company's retention ratio when determining whether to invest in a company. The retention ratio is the percentage of net income the company holds in retained earnings. You calculate the retention ratio with the following formula:
Retention ratio = (net income – dividends) / net Income
Returning to the example above, your retention ratio would be calculated as follows:
($250,000 - $100,000) / $250,000 = 0.6 or 60%
In other words, you're keeping 60% of your company's net income in retained earnings rather than paying them out in dividends.
Most savvy investors look for a balance between dividends and reinvestment because companies that distribute all of their profits to shareholders can hinder their ability to generate profits in the future.
Find out more about Business Accounting