RETAINED EARNINGS: HOW TO CALCULATE THEM AND EXAMPLES - DUDAS - 2025

The retained earnings are the net cumulative gains to date, or profits obtained by a company after accounting for dividend payments to shareholders.

Also called a profit surplus. It represents the reserve money that is available for the administration of the company, to be reinvested in the business.

Source: pixabay.com

This amount is adjusted whenever there is an entry in the accounting records that affects an income or expense account. A large retained earnings balance means a financially healthy organization.

A company that has experienced more losses than gains to date, or that has distributed more dividends than it had in the retained earnings balance, will have a negative balance in the retained earnings account. If so, this negative balance is called the accumulated deficit.

The retained earnings balance or accumulated deficit balance is reported in the stockholders' equity section of a company's balance sheet.

What are retained earnings?

A company generates profits that can be positive (gains) or negative (losses).

Utilization of earnings

The following options broadly cover all the possibilities on how the earnings obtained can be used:

- Distribute totally or partially among the shareholders of the company in the form of dividends.

- Invest to expand business operations, such as increasing production capacity or hiring more sales representatives.

- Invest to launch a new product or variant. For example, the refrigerator manufacturer seeks to produce air conditioners. On the other hand, the chocolate cookie manufacturer launches orange or pineapple flavored variants.

- Be used for any possible merger, acquisition or association that leads to better business prospects.

- Repurchase of shares.

- They can be held in reserve pending future losses, such as the sale of a subsidiary or the expected result of a lawsuit.

- Pay any outstanding debt that the company may have.

The first option leads to the profit money leaving the company accounts forever, because the dividend payments are irreversible.

All other options immobilize the money from the earnings for use within the business. Such investments and financing activities constitute retained earnings.

Management vs shareholders

When a company generates surplus income, part of the shareholders can expect some income in the form of dividends. This is as a reward for placing your money in the company.

Traders looking for short-term profits may also prefer to receive dividend payments, which offer instant profits. On the other hand, company management may think that the money could be better used if it is kept within the company.

Both management and shareholders may like the company to retain earnings for different reasons:

- By being better informed about the market and the business of the company, the management can envision a high-growth project, which they perceive as a candidate to generate substantial returns in the future.

- In the long term, such initiatives can lead to better returns for the company's shareholders, rather than those obtained from dividend payments.

- It is preferable to pay a debt with high interest, instead of paying dividends.

Frequently, the management of the company decides to pay a nominal amount of dividends and retain a good part of the profits. This decision is beneficial to all.

Dividends and retained earnings

Dividends can be distributed in cash or in shares. Both forms of distribution reduce retained earnings.

As the company loses ownership of its liquid assets in the form of cash dividends, it reduces the value of the company's assets on the balance sheet, affecting retained earnings.

On the other hand, although the stock dividend does not lead to a cash outflow, the stock payment transfers a portion of the retained earnings to the common stock.

How to calculate them?

Retained earnings are calculated by adding the net earnings (or subtracting the net losses) from the retained earnings for the prior period, and then subtracting any dividends paid to shareholders. Mathematically the formula would be:

Retained earnings = Retained earnings at the beginning of the period + Net profit (or loss) - Cash dividends - Stock dividends.

The amount is calculated at the end of each accounting period (quarterly / annually). As the formula suggests, retained earnings depend on the corresponding figure from the previous term.

The resulting number can be positive or negative, depending on the net profit or loss generated by the company.

Alternatively, the company that pays a large amount of dividends, exceeding the other figures, can also lead to retained earnings turning negative.

Any item that affects net profit (or loss) will affect retained earnings. Among these elements are: sales income, cost of merchandise sold, depreciation and operating expenses.

Examples

One way to evaluate a company's success using retained earnings is by using a key indicator called "retained earnings at market value."

It is calculated for a period of time, evaluating the change in the price of the shares with respect to the earnings retained by the company.

For example, over a five-year period, between September 2012 and September 2017, Apple's stock price increased from $ 95.30 to $ 154.12 per share.

During that same five-year period, the total earnings per share was $ 38.87, while the total dividend paid by the company was $ 10 per share.

These figures are available in the "key indicators" section of the company reports.

The difference between the earnings per share and the total dividend gives the net earnings retained by the company: $ 38.87 - $ 10 = $ 28.87. In other words, during this five-year period, the company had retained earnings of $ 28.87 per share.

During that same time, the price of its shares increased by $ 154.12 - $ 95.30 = $ 58.82 per share.

Calculation of the indicator

Dividing this increase in price per share by the retained earnings per share gives the factor: $ 58.82 / $ 28.87 = 2.04.

This factor indicates that for every dollar of retained earnings, the company managed to create a market value of $ 2.04.

If the company had not withheld this money and borrowed with interest, the value generated would have been less, due to the interest payment.

Retained earnings offer free capital to finance projects. This enables efficient value creation by profitable companies.

References

1. Investopedia (2018). Retained Earnings. Taken from: investopedia.com.
2. Steven Bragg (2017). Retained earnings. Accounting Tools. Taken from: accountingtools.com.
3. CFI (2018). Retained Earnings. Taken from: corporatefinanceinstitute.com.
4. Harold Averkamp (2018). What is retained earnings? Accounting Coach. Taken from: accountingcoach.com.
5. Investing Answers (2018). Retained Earnings. Taken from: investinganswers.com.