Calculate retained earnings are like a running reckoning of how much profit a company has managed to clasp onto since it was founded. Retained earnings go up whenever a company has managed to earn a profit, and similarly, they go down every time the owner has withdrawn some of those profits to pay a dividend to the shareholders.
Or to put it simply, retained earnings is the amount of net income left over after the company has paid its dividend to the shareholders. As we all know, a business generally produces earnings that can be either a positive earning (i.e., profit) and a negative earning (i.e., loss).
Positive profits give a lot of space to the business owner(s) or the board of directors to do whatever they desire to utilize the surplus money that is earned. More than often this positive earning is paid to the shareholders, but if the management/owner decides then it can also be plowed back into the company for the company’s growth. In this case, the money which is not paid to the shareholders can be counted as retained earnings of the company.
Let us now look at the retained earnings formula.
RE= BP+ Net Income (or Loss) -C-S
BP= Beginning Period RE
C= Cash dividends
S= Stock dividends
What Does Retained Earnings Tell You?
A large portion of the long-term shareholders may expect some sort of regular income through dividends as a reward for investing their money in the company— this happens, whenever a company produces a surplus in income. Whereas, traders who search for short-term gains may also choose to get dividend payments which offer instant gains to them.
Now, you may even ask why dividends are preferred over gains on stock. The sole reason behind it is many jurisdictions allow dividends to be a tax-free income, while gains on any stocks are subjected to taxes.
Then again, the company’s management may also believe that they can utilize the money better if the money is retained inside the company. In the same way, there might be shareholders who trust the management’s proficiency blindly and may even prefer allowing the management to retain the earnings in the hope of getting much higher returns even with the taxes included.
Utilizing Retained Earnings
Let us briefly look over some possible ways by which we can use retained earnings.
- First and foremost, the surplus money can be distributed among the business owners in the form of dividends. Whether to distribute it fully or partially, that decision depends upon the company’s management.
- The surplus can also be used as a factor that can add to the business’ development. For instance, the surplus can be invested to expand the prevailing business operations, like increasing the capacity of production of the prevailing products or something as simple as hiring more sales representatives.
- The surplus can be used to launch a brand-new product or variant. For instance, a chocolate cookie manufacturer launching orange or apple-flavored variants.
- The surplus money can be used for any possible merger, acquisition, or partnership that can eventually lead to an improved business prospect.
- The surplus can also be simply used for share buybacks.
- The earnings may also be utilized to repay any outstanding debts of the business that it may have.
The primary option— as we know— leads to the earnings money going out of the books and accounts of the company forever as dividend payments are irretrievable. Though all the other options in the list retain the earnings money for usage within the company, and such funding activities and investments establish the retained earnings (aka RE).
By general definition, retained earnings are the growing net earnings (or profits) of a business after bookkeeping for dividend payments. It is also known as earnings surplus and embodies the reserve money, which is accessible to the business management for reinvesting back into the firm. When it is expressed as a percentage of total earnings, it is also known as ‘retention ratio’ and is equal to ‘1 – dividend payout ratio’.
While the last option of clearing off debts also leads to the surplus earnings going out, it still has an impact on the business accounts as the firm’s liabilities decreases which makes the firm’s balance sheet a tad stronger than before. Saving future interest payments just further qualifies it for inclusion in retained earnings.
Management and Retained Earnings
The main decision to retain the earnings or to distribute them among the company’s owners is generally left up to the company’s management. However, the decision can be thrown down the gauntlet by the company’s shareholders through a majority voting system as shareholders are the real owners of the company.
The shareholders and company’s management may like the business to recollect the earnings for several various reasons. The management may have a high growth project in their vision if they are being informed and conversant about the market’s state and the company’s business. The high growth project might even be perceived as a candidate to produce considerable returns in the future.
If we look up at it in the long run, such initiatives may even lead to better revenues for the company shareholders instead of that gained from the dividend payouts. Instead of dividend payments, paying off high-interest debt is also preferred by both the shareholders and the company’s management.
More than often, a balanced tactic is taken by the company’s management. It entails paying out a trifling amount of dividend and retaining a good portion of the earnings, which is a win-win situation.
Calculate Retained Earnings – Example:
Let us see an example of how to reckon retained earnings.
Let’s suppose your company went into business on February 1, 2020. Your retained earnings account on February 1, 2020, will read ₹0 as you have no earnings to retain.
Now, let us suppose that in February you earned ₹50,000 as your net income, but you don’t issue any dividends.
That results in your company’s retained earnings being ₹50,000 on March 1, 2020.
Now, let’s put our formulae into account:
Retained earnings= Beginning period RE+ Net Income – Dividends
₹50,000= ₹0+ ₹50,000 – ₹0
This perfectly makes sense since you earned ₹50,000 as your profit and then retained all of them.
How to Calculate the Effect of Cash Dividend on Retained Earnings?
Now, let us see how you can calculate the retained earnings if you have given a cash dividend to your shareholders.
Now, let us suppose that the business has really picked up its pace and is doing so well that in March you earn a profit of ₹1,00,000. The business is doing so well that at the end of March, you decide to reward your shareholders by paying 25% of your net income in the form of dividends.
That 25% of your net income will be considered as the cash dividend which will be subtracted from your net income in the calculation of the retained earnings.
How to Calculate the Effect of a Stock Dividend on Retained Earnings?
Many times, a company may want to reward its shareholders with a dividend that is not in cash form, that is without giving away any cash. It then issues what’s called a stock dividend. This is just a normal dividend payment in the form of shares of a company, rather than cash. Reckoning retained earnings after a stock dividend entails a few extra stages to figure out the actual number of dividends a company will be distributing.
First and foremost, the company will have to figure out the fair market value (aka FMV) of the shares the company will be distributing. Companies also generally issue a percentage of all their shares as a dividend (i.e., a 6% stock dividend means the company will be giving away 6% of its equity shares). So, the company first has to figure out exactly how many shares that is.
Putting it in equation form, the formulae for retained earnings in a stock dividend will be:
Retained earnings= Beginning period RE + Net income – (n number of shares x FMV of each share).
What About Shareholder’s Equity and Working Capital?
Even though they all have to do with the equity section of the company’s balance sheet, working capital and the shareholder’s equity (also known as stockholder equity, paid-in capital, or owner’s equity) do vary from retained earnings. Shareholder’s equity measures how much a company is worth if it ever decides to liquidate all of its assets. The formulae for reckoning that is as:
Shareholders’ equity= Total assets – Total liabilities
Working capital is a measure of rod for the resources the business has at its disposal to deposit to the day-to-day operations. To get working capital, you just need to subtract all of your current liabilities from your current assets.
Working capital= Current assets – Current liabilities
So, that was all about retained earnings and how to calculate retained earnings. We hope this article did its sole purpose and helped you in any way possible.
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