To effectively grow and maintain a thriving business, it’s important to keep a firm grasp on the accounting side of things. By generating regular reports and analysing how much money you are making and losing each reporting period, you will be able to make better business decisions. These reports should include a statement of retained earnings.
Once you’ve deducted cost of goods sold, expenses, depreciation, interest and taxes from your revenue, you are left with your net income.
Retained earnings are the amount of net income left over for your business after it has paid out dividends to its shareholders.
If your business has made money over a specific period, you have the option of injecting it back into the business to to trigger further growth and profitability.
3 things to know about retained earnings
This post will explore three key issues:
- Retained earnings vs. revenue.
- How to calculate retained earnings.
- How retained earnings can be used by a business.
Once you know what retained earnings are, you can start to think about how they can help you grow your business.
1. Retained earnings vs. revenue
Whether you’re a company owner, board member or on a management committee, It’s important to understand the difference between revenue and retained earnings.
Revenue (or gross sales) is the total income generated by a company before operating expenses and overhead costs are deducted.
For instance, if you own a clothing brand, your revenue is calculated purely on sales that you have made over a specific period of time.
Once you’ve deducted all your necessary business costs such as overhead taxes and shareholder dividends, you will ideally have a portion of your earnings left over. This is what’s known as your retained earnings.
What you can do with retained earnings
The decision to retain earnings or distribute them among company shareholders (if any) is usually made by the business owner or the board of directors. It’s their job to decide how the money should best be used in order to allow the business to perform at its peak.
Owners or managers of some businesses, particularly those in an active growth phase, may decide not to pay dividends to shareholders over a certain period of time. Instead, they hold on to all retained earnings to spur growth.
Every business is unique. One business might use its retained earnings to hire additional staff, while another could use it to expand their product line or pay off debt.
2. How to calculate retained earnings
A statement of retained earnings is calculated using this formula:
+ Beginning (existing) retained earnings
+ Net income during the reporting period
- Dividends paid
= Retained earnings for the reporting period
It’s important to keep in mind this figure is by no means stagnant. Your retained earnings figure will change daily, so it’s important to keep track of it over regular reporting periods.
Can earnings ever be negative?
It’s possible for a business to report negative retained earnings due to a variety of circumstances. This might include:
- Distribution of large dividends that exceeds the retained earnings balance
- Big losses incurred across the business
Company shareholders expect regular dividend payments in return for investing their money, but it’s ultimately up to owners/managers to decide if the retained earnings would be better used within the company.
Shareholders may challenge the decision to not pay out dividends in a specific reporting period if they don’t believe it is justified.
Ultimately, shareholders and company management should have a mutual sense of trust that each financial decision is in the best interests of the business.
When would it be smarter to keep retained earnings?
A private company may do anything it likes with its retained earnings, as it has no shareholders.
Managers of a public company may decide to hold onto retained earnings for research and development or anything else that will lead to an increase in the value of company shares. Although they are denied dividends in the short run, their patience is rewarded in time.
This is a strategic decision for any publicly held company, one that should be based on careful research and expert advice.
3. How retained earnings can be used by a business
There are many different ways a business owner or CEO can use retained earnings to grow the business. For example, it could be used to:
- Expand or improve existing business operations, possibly by increasing production capacity of existing products or hiring more sales staff
- New product launches — new variants, flavours, styles, etc (depending on the type of business)
- Mergers, acquisitions or partnerships to expand market share
- Purchase back shares from existing shareholders at a higher than market price
- Repay outstanding loans or debts the business has taken on
The goal is to identify and invest in opportunities that will pay off in the long run.
Retained earnings can help your business thrive
Whether you’re just starting out or have been in business for years, understanding what retained earnings are and how they can be used to grow your business is key to long-term vitality.
If used wisely, retained earnings can help a business go from strength to strength.
If you’re keeping track of your accounts on your own, use one of the many online tools to monitor your revenue, net income and retained earnings.
If you have an accounts team crunching your numbers, ensure a well-structured and concise report is generated each reporting period so you and other stakeholders can keep a close eye on how your business is performing.