Both investors and company managers are interested in profits that are later distributed as dividends and kept as retained earnings. Before talking about retained earnings calculation, we want to ensure that you have a clear idea of what this term means.
Retained earnings represent part of the equity that was not distributed to shareholders as dividends. Only the owners can decide how to distribute the income, and it must be drawn up by the minutes of the general meeting of the shareholders. Some income that remains after the payment of dividends may be reinvested in the development of the company and working capital, or it may be designed for paying off past losses and debts.
Along with issued capital, accumulated earnings are a source of asset acquisition. The retained earnings account balance represents the amount of net profit for the entire life of the company, net of losses, dividend payments, and gains reinvested in issued share capital. Retained earnings are not an asset of the enterprise. Its presence means that the assets of the enterprise increased due to operations for which the profit was received.
Retained Earnings Reports
The vast majority of companies include four types of financial statements in their annual report: balance sheet, profit and loss statement, statement of retained earnings, and cash flow statement. The announcement of retained earnings reflects the reasons for changes in the structure of accumulated earnings for the reporting period. For example, the basic structure of the statement of retained earnings looks like this:
If a company changes its accounting principles and methods, the beginning retained earnings will need to be adjusted. Other adjustments may include corrections to any portion of the net income, such as understated or overstated expenses, and any mathematical/human errors as well as any modifications to the dividends paid last year. If the company has to make adjustments, they will also be noted in the Retained Earnings Statements for the reporting year because one cannot make changes to reports that have already been submitted. The Statement of Retained Earnings will then look as follows:
It should be noted that beginning or ending retained earnings are not always definite. Negative retained earnings are possible when a company pays dividends that exceed the amount of retained profits in the account or when there is no sufficient amount of accumulated profits to cover losses for one or more years that a company might experience.
Retained Earnings Formula
It is relatively easy to calculate retained earnings when you got the formula in front of you. Besides retained earnings formula, you would also need to know the net income or loss for the reporting year, which can be found in the income statement. Also, retained earnings calculation involves retained earnings from the previous year, which can be retrieved from the balance sheet or statement of retained earnings for the last year, and dividends declared and paid during the current year.
After gathering all the necessary data for the calculations, you can calculate retained earnings using the following formula.
If the company in the current period received a net loss instead of a profit, then in the calculation, one would subtract the damage instead of adding the benefit.
The ending balance for retained earnings is then reported on the balance sheet. When the net loss for a given period is higher than retained earnings for the same period, the amount of retained earnings may be harmful, which will create a deficit. As you can see from the retained earnings formula, anything that would affect the income will be reflected in the retained earnings. Management decisions regarding dividend payments will also alter.
Example Calculation of Retained Earnings
Let’s assume that you are calculating retained earnings for the year 2020. The first thing you would need to do is obtain retained earnings amount from the past year’s balance sheet or statement of retained earnings for the year ending 2019. Next, you need to ensure that there were no adjustments to the previous year’s net income. If there were any corrections, you would add or subtract that amount from the retained earnings at the end of 2019.
Now that you have the beginning retained earnings for the year 2020 that are corrected, if necessary, you will add net income (or subtract the loss). The net income value is taken from the Income Statement for the year ending 2020. The cash flow statement financing activity part would have the cash dividend amount if any were paid. The amount of stock dividends paid is declared at the meeting of the board of directors.
Thus, if the retained earnings for the year ending 2019 equaled $480,000 and there was an adjustment for a depreciation error of $50,000, then we will start with retained earnings of $430,000. Next, we add net income, which let’s assume equaled to $110,000. We get a subtotal of $540,000. The company did not pay any stock dividends, but it did have cash dividend payments equal to $25,000. We subtract $25,000 from our subtotal and receive an ending retained earnings amount the same to $515,000. This amount will then be included in the balance sheet.
How Much Profit to Retain?
It is much harder to decide what portion of net income to retain and what percentage to distribute as dividends than to calculate retained earnings amount. The company has the right to decide on a quarterly, semiannual, or semiannual basis to distribute its net profit among the shareholders in the company. The decision to determine how much profit should be distributed among the shareholders (stockholders) is taken during a general meeting of the board of directors.
The decision of the owners on the distribution of profit is documented in a protocol. If the company consists of a single participant, then the corresponding decision is taken solely by that individual and drawn up in writing. The amount of dividend payment is determined in proportion to the shares owned by the participants unless otherwise provided by the charter of the organization.
Income is significant for shareholders, but they equally care about how that income is distributed. They are of course interested in receiving returns on their investments in the form of dividends, but they should also understand that a company needs to keep some of these profits to provide them with even higher returns in the future. In fact, by agreeing for lower dividend payments, shareholders, are in a way reinvesting their money in hopes for more significant gains.
However, shareholders need to check where the company is planning to use this retained income and how effectively it has used it before. Otherwise, their return on investment might be low, and changes in company management might be necessary to ensure that money that belongs to the shareholders is used wisely and gets multiplied.
Retained earnings can also be calculated as a percentage of total revenues. In this case, we will be talking about the retention ratio. The retention rate refers to the portion of the income received or the fixed amount of money that the business leaves at its disposal after all dividend payments to investors have been made. However, most often, this ratio is set as a percentage. Sometimes this term may be referred to as a back plow ratio.
The process of determining the retention rate is quite simple since it relates to net income and not to gross income. This means that all taxes have already been deducted from their amount of income used to determine the ratio. The retention rate is calculated as the ratio of the difference between the amount of net income and dividends paid to the amount of net income.
For example, if a company in the current period made a net income of $230,000 and paid dividends of $ 50,000, then using the retained earnings formula one can calculate that retained earnings will equal to $180,000. In this case, the retention ratio will be equal to (230,000-50,000) / 230,000 = 78.26%.
The goal of most companies is to maintain the highest retention rate while paying the number of dividends that will be attractive to investors. When the company can achieve this balance, more money that can be invested in improving existing activities, expanding the business, entering new markets, and financing research and development activities will be available.
Leaving at its disposal a substantial part of net income, it is possible to carry out strategic planning of activities, which, ultimately, will benefit both the owners of the company and investors. Many investors find it desirable that the company set aside a sufficient amount of retained earnings to ensure future growth and development. When a company continues to have a relatively low retention rate, it is necessary to establish the reasons for this situation. This can lead to changes in the production process, an estimate of the cost of raw materials used, or to a reorganization of the corporate structure to eliminate activities that are obsolete or unproductive. The idea of such actions is to cut costs without adversely affecting the quality of the company’s products or services. This will allow increasing the amount of net income, which will, in turn, increase the retention rate.