Retained earnings are the amount of profit a company has left over after paying all its direct costs, indirect costs, income taxes and its dividends to shareholders. This represents the portion of the company’s equity that can be used, for instance, to invest in new equipment, R&D, and marketing.
When accumulated year after year, retained earnings are known as “accumulated profits.”
Your business’s retained earnings is something banks look at before lending you an additional amount.
“Year after year, retained earnings are added to the balance sheet and become part of the company’s equity with the money that was initially invested by shareholders,” says François-Xavier Lemay, Manager, Business Centre, BDC. “That’s what creates the value of the business.”
How are retained earnings calculated?
Let’s take the example of a cosmetics company with $10 million in sales.
Several elements are then subtracted:
| Variable or direct costs (e.g. inventory, salary of staff working on goods sold, electricity consumed to manufacture the products) | $4 million |
| Fixed or indirect costs (rent, insurance, marketing, telecommunications, training, salary of administrative personnel) | $5.4 million |
| Taxes | $100,000 |
| Net profit | $500,000 |
| Dividends | $100,000 |
The formula for calculating retained earnings is:
Sales ($10M) - Variable costs ($4M) - Fixed costs ($5.4M) - Taxes ($100,000) = Net profit (500,000) - Dividends ($100,000) = Retained earnings ($400,000)
“We would then add the $400,000 as retained earnings to the shareholders’ equity of the company’s balance sheet,” Lemay says.
Where are retained earnings indicated in financial statements?
Retained earnings appear in the shareholders’ equity section of the balance sheet.
In most financial statements, there is an entire section allocated to the calculation of retained earnings.
For smaller businesses, the calculation of retained earnings can be found on the income statement, as shown below.
What is the relationship between net profit, dividends and retained earnings?
Net profit is the profit a company has left over after all the variable costs, fixed costs and taxes have been paid.
In the example above, the net profit would be calculated as follows:
Sales ($10M) - Variable costs ($4M) - Fixed costs ($5.4M) - Taxes ($100,000) = Net profit ($500,000)
To obtain the retained earnings, the dividends are subtracted from the net profit.
Net profit ($500,000) - Dividends ($100,000) = Retained earnings ($400,000)
How are retained earnings analyzed?
Keep in mind that banks look at retained earnings before they make a loan to a company.
“A bank looks at the company’s debt-to-equity ratio to assess the risk,” Lemay says. “Banks will generally lend about three or four times what the company has in terms of equity, a major component of which is retained earnings.”
Using the example above, the company has $400,000 in retained earnings, so it can expect to get an increase in borrowing capacity of $1.2 or $1.6 million to speed up its growth.
“Owners could not take out $500,000 in dividends from the company and then turn around and go to a bank and ask for $1 million,” Lemay says. “If you need a loan for a project, you have to leave money in the business in order to reduce the risk for the bank. As an entrepreneur, you can’t have your cake and eat it too!”
As a seasoned financial expert with a comprehensive understanding of corporate finance and accounting principles, I've delved deeply into the intricacies of financial statements and the critical role of retained earnings in evaluating a company's financial health. My expertise extends to analyzing the relationship between net profit, dividends, and retained earnings, as well as deciphering the impact of these financial metrics on a company's ability to secure loans from financial institutions.
Let's break down the key concepts mentioned in the provided article:
Retained Earnings:
Retained earnings represent the cumulative amount of profit that a company retains after deducting direct costs, indirect costs, income taxes, and dividends to shareholders. These earnings can be reinvested in the business for activities like purchasing new equipment, funding research and development (R&D), and supporting marketing initiatives. Over time, retained earnings become "accumulated profits," contributing to the overall equity of the company.
Calculation of Retained Earnings:
The formula for calculating retained earnings involves subtracting all costs and expenses (variable and fixed costs, taxes) from the sales revenue, and then deducting dividends from the resulting net profit. The final figure is added to the shareholders' equity on the balance sheet.
Placement in Financial Statements:
Retained earnings are typically indicated in the shareholders' equity section of the balance sheet. Larger businesses often have a dedicated section in financial statements for the calculation of retained earnings. For smaller businesses, this information may be found on the income statement.
Relationship between Net Profit, Dividends, and Retained Earnings:
Net profit represents the amount of profit left after accounting for variable costs, fixed costs, and taxes. The retained earnings are obtained by subtracting dividends from the net profit. In essence, retained earnings are the portion of profit not distributed to shareholders as dividends.
Analysis of Retained Earnings:
Financial institutions, such as banks, closely examine a company's retained earnings when considering loan applications. The debt-to-equity ratio is a key metric used by banks to assess risk. A higher proportion of equity, including retained earnings, strengthens a company's borrowing capacity. In the example provided, the $400,000 in retained earnings could potentially translate to a significant increase in borrowing capacity, enabling the company to pursue growth opportunities.
In summary, the article underscores the importance of retained earnings as a critical component of a company's financial structure. It emphasizes how a judicious approach to managing retained earnings can enhance a company's ability to secure loans and facilitate sustainable business growth.
