What You Need to Know about Retained Earnings - Our Guide
A business basically exists in order to earn money. If there’s one thing that you should pursue when running a business, it’s the return of investment (ROI). At the end of the day, you should be asking yourself if you’re making any money from your business.
There are many financial terms associated with running a business. Chances are you’ll look at your balance sheet and wonder what retained earnings are. Retained earnings say a lot about the financial health of your business. This is one aspect of your business’s finances that you need to familiarize yourself with, as retained earnings will be able to tell you if your business is earning or not.
In the next section, we will tell you more about retained earnings, how they are calculated, how they differ from net profit, when you need to use them, and why they matter to a business.
Retained Earnings and Calculations
In a nutshell, retained earnings refer to the profits that your business has earned, minus any dividends or other distributions. They are sometimes called member capital, which is usually found in the equity section of your balance sheet. This is the formula used to calculate retained earnings:
● Beginning Retained Earnings + Profit/Loss – Dividends = Retained Earnings
For example, you have just started a business. Your beginning retained earnings is $0. If you make a profit of $25 during your first month, your retained earnings are now $25, as follows:
● Beginning Retained Earnings = $0
● Profit/Loss = $25
● Dividends = $0
● $0 + $25 - 0 = $25
Here’s a more complex example. Your business has been operating for months with a healthy profit. After your expenses and any liabilities are covered, you still have some profit left to pay out dividends to shareholders. The money left after you’ve paid your shareholders is held onto by the business, and that amount is your retained earnings. See the computation below:
● Beginning Retained Earnings = $50
● Profit/Loss = $1,000
● Dividends = $500
● $50 + $1,000 - $500 = $550
Difference between Retained Earnings and Net Profit
Retained earnings and net profit are somewhat similar yet different. Basically, your net profit is what’s left after you’ve subtracted your operating expenses from your revenue. Retained earnings are what’s left of your net profit after the dividends are paid out and the beginning retained earnings are factored in. For instance, you have made $20,000 in revenue and need $10,000 to cover expenses. Subtracting $10,000 expenditure from the $20,000 revenue, that leaves you with a net profit of $10,000. However, you need to pay your two shareholders $2,000 each. What’s left then is your retained earnings of $6,000.
Final Words: When to use and why it matters
Now that we’ve told you what retained earnings are and how they are calculated, you may be wondering, “What does this mean for my business?”
Retained earnings serve as a financial barometer of sorts. Looking at your retained earnings will tell you if your business is financially healthy. If your retained earnings are quite low, then you better keep this money in the business and hold off on paying any large dividends. However, if you have enough retained earnings, they can be reinvested into your business.
In the end, retained earnings provide a much clearer picture of the financial health of your business. Chances are financial determinants such as revenues and expenses can fluctuate month-to-month. You can’t just rely on the net profit alone. Looking at the retained earnings will give you a better perspective on whether or not your business is making money.
Going through the process of the accounting cycle takes time and effort. However, the results are still worth it. In addition, you can hire a bookkeeper to take care of the accounting cycle of your company. If you’re looking for Bookkeeping by QuickBooks Certified ProAdvisors, get in touch today! We’re happy to help.