Retained earnings are the net income of a business after dividends have been paid out to shareholders and/or owners.
If there's a positive balance instead of a negative one (which might be a bad sign in regard to the business's financial health), a company has several ways to use the surplus income besides dividing it (in part or completely) as dividends to shareholders, according to the number of shares each one holds. This includes:
- Investing the money in business growth
- Funding a product launch
- Repaying debt
- Taking care of operating expenses
- Setting up mergers, acquisitions, or partnerships
- Doing share buybacks
Retained earnings enable you to track how much money you have accumulated in an income statement using a formula. On a company's balance sheet, retained earnings are put under the equity section. Other sections include total liabilities and assets. Since retained earnings can be used to buy assets, people sometimes wonder if retained earnings are an asset.
Skynova's all-in-one accounting and invoicing software made for small businesses can help keep track of frequent financial transactions and each statement of cash flows, enabling you to keep accurate records of your income, expenses, sales tax, and payments. You can also store receipts, have a choice between cash and accrual accounting, and run reports when you need to.
Why Aren't Retained Earnings an Asset?
While you can use retained earnings to buy assets, they aren't an asset. Retained earnings are actually considered a liability to a company because they are a sum of money set aside to pay stockholders in the event of a sale or buyout of the business.
Because retained earnings basically belong to the shareholders, they are not an asset but are instead found on the liabilities side of the balance sheet, under reserves and surplus in the stockholders' equity section.
It is essential for businesses large and small to accurately keep track of their retained earnings, as well as their total assets and liabilities. A limited liability company (LLC) may have shareholders who are not liable for the company's debt, but they are — as in a general partnership — still entitled to receive distributed profits. Any profits not distributed at the end of a fiscal year are considered retained earnings.
What Are Retained Earnings on a Balance Sheet?
A balance sheet is a key financial statement that provides a telling snapshot of what a company owns and owes, as well as revealing how much shareholders have invested in it. During a specific financial period, it reports the business's revenue, liabilities, and numbers for the shareholders' equity section.
A basic accounting equation on a balance sheet could be understood as:
| Owner's Equity | |
|---|---|
| = | Assets - Liabilities |
A balance sheet could be used by investors to see what cash dividends and stock dividends they might be entitled to (if the retained earnings are not invested in some other aspect of sustaining or growing the business) or by an analyst to get financial insight into a company.
A potential buyer might use the equity section of the balance sheet and its line items to decide whether there are assets that could be stripped away without damaging the underlying business. The retained earnings balance can also be used to calculate financial ratios, including debt-to-income and acid-test ratios.
Retained Earnings vs. Profit
Retained earnings are not the same as profit. Both are required to judge a company's financial health but don't reveal the same thing exactly. Profit is the company's bottom line - its total income earned from the sale of goods and services. It usually refers to net income, or the total income minus the cost of doing business (e.g., overhead costs and payroll). Gross income is the income for goods sold minus the cost of goods sold.
Retained earnings are the portion of the profit saved to make shareholder dividend payments or for other future uses, such as growing the company and/or product lines or paying off debts. Shareholders might see value in using the money for other things than immediate cash dividends if it is invested into something likely to become highly profitable and pay even bigger dividends down the road.
What's the Retained Earnings Formula?
Your retained earnings account provides an ongoing count of how much money your business has been able to hold onto since it launched. As you reinvest your business or pay shareholder dividends, your retained earnings dip down. As you earn stronger profits, the earned savings usually go up. They can fall into a negative balance with accumulated deficits if times have been particularly tough for your company or if it's in its startup years when you are trying to build up the business.
Using the retained earnings formula is straightforward:
| Retained Earnings | |
|---|---|
| = | Current Retained Earnings |
| + Profit or − Loss | |
| − Dividends | |
Good accounting software, such as Skynova's solution for small businesses, can help you with these types of calculations.
Your current retained earnings are simply whatever you calculated during your last financial period. The same goes for the net profit/net loss, calculated by the month, quarter, year, or whatever your accounting period is. Whatever you paid shareholders in dividends for the period will reduce the amount shown in the statement of retained earnings.
If you had $2,000 in current retained earnings and recorded monthly product sales of $8,000 and decided to pay $2,000 in dividends to each of the company's three shareholders, for instance, you would be left with $4,000 in retained earnings: $2,000 + $8,000 - $6,000 = $4,000.
Retained earnings must be reported at the end of each accounting period. Comparing your retained earnings from one accounting period to the next can help provide an important metric in how your company is doing financially and serve to guide future business decisions.
Who Decides How Retained Earnings Are Used?
Company management usually decides if profits are used to pay shareholder dividends or set aside for retained earnings. That said, it's possible for shareholders to challenge this through a majority vote, as the real business owners decided their purchase of common stocks. Shareholders often find themselves on the same side as company management when it comes to retained earnings, however.
They both may see them as working capital to pay off high-interest debt or invest in growth that will make the company even more profitable given some more time. If money is paid in dividends, it is out of the company and off the books. If it is kept as retained earnings, it remains on the books and is available for use within the business.
A balance is often struck, with some of the profits paid out in dividends and a portion of it kept as retained earnings.
Let Skynova Help You Manage Your Small Business Bookkeeping
It is important to do accurate and full accounting for your small business so you have a clear picture of your business's financial picture, have the data you need for important business decision-making, and don't land in trouble during tax time.
With Skynova's invoicing and accounting software, you have an easy-to-use, cost-effective solution made for small businesses like yours. Try it for free for 21 days (no credit card required), and we are sure you will join the growing ranks of business owners who have used it to help organize and run their companies more successfully.
You might also be interested in checking out our complete suite of small business software modules, many of them template-driven. Whether you want to create customizable invoices (including recurring invoices); create, assign, and send professional work orders online; or request a retainer before starting work, Skynova has you covered with easy, affordable small business solutions.
Notice to the Reader
The content of this article is meant to be used as general information and help. It may not apply to your specific situation. It's wise to always consult with a tax professional for guidance tailored to your particular needs.
