What are retained earnings? Definition and FAQs

Table of contents

• Retained earnings (definition)
• How to calculate retained earnings
• How retained earnings affect the balance sheet
• What are retained earnings used for
• Rules, pros and cons for retained earnings
• What are retained earnings for sole traders and partnerships
• Managing retained earnings with Xero
• FAQs on retained earnings

Key takeaways

• Calculate retained earnings by adding your net profit after tax to previous retained earnings, then subtracting any payments made to owners or shareholders.
• Utilise retained earnings strategically to fund daily operations, growth investments, product development, acquisitions, emergency reserves, or debt reduction rather than letting cash sit idle.
• Recognise that retained earnings appear in the owner's equity section of your balance sheet and strengthen your business financially by either increasing assets or decreasing liabilities.
• Implement accounting software to automatically track retained earnings calculations and monitor changes in real time, enabling smarter reinvestment decisions and financial planning.

Retained earnings (definition)

Retained earnings are the net profits a business keeps after paying expenses, taxes, and any distributions to owners. This money stays in the business to fund future growth, operations, or emergencies.

When your business makes a profit, you can either distribute it to owners or keep it in the business as retained earnings.

How to calculate retained earnings

Retained earnings formula:

Retained earnings = net profit after tax – payments to owners + previous retained earnings

Breaking down the calculation:

• net profit after tax – your business profit after all expenses and taxes
• payments to owners – dividends, drawings, or distributions made to shareholders or owners
• previous retained earnings – the accumulated amount from prior periods

How retained earnings affect the balance sheet

Retained earnings appear as equity on your balance sheet. Australian accounting standards officially list retained earnings as one of the key classes of equity to be disclosed on a company’s financial statements. They increase your business’s net worth and represent money that belongs to the business, not creditors.

How retained earnings affect your balance sheet:

The accounting equation is: Owner's equity = Assets - Liabilities

When you retain earnings, you either:

• Increase assets: The cash stays in your bank account or gets invested in equipment, inventory, or property
• Decrease liabilities: You use the money to pay down debts

Both scenarios boost your owner’s equity, making your business financially stronger.

The other way to increase owner’s equity is by selling shares in the business. As such, retained earnings are the main way that sole traders – who cannot sell shares – can grow owner’s equity.

What are retained earnings used for

Common uses for retained earnings:

• Daily operations: Cover payroll, rent, utilities, and other ongoing expenses
• Growth investments: Purchase new equipment, open locations, hire staff, or fund marketing campaigns
• Product development: Support research and development of new products or services
• Acquisitions: Buy out competitors or complementary businesses
• Emergency reserves: Build a financial buffer to survive economic downturns or unexpected challenges
• Debt reduction: Pay down loans early to reduce interest costs and improve cash flow

Rules, pros and cons for retained earnings

Retained earnings are reported on the balance sheet in the owner’s equity section and on the statement of changes in equity. However, official accounting standards permit some businesses to present a combined statement of income and retained earnings if changes to equity are limited to profits, dividends, and certain corrections.

As noted, they can fund ongoing operations, growth, research and development, mergers and acquisitions, or they can be saved to build financial resilience. Businesses in some higher-risk industries may be required by law – or by their lenders – to retain a certain portion of earnings. This is typically required of businesses that have expensive assets, as they will need to have liquid cash to replace those assets if something goes wrong.

Advantages of retained earnings:

• provide cash reserves for unexpected expenses or opportunities
• enable expansion without taking on debt or selling equity
• reduce reliance on external funding sources

Potential disadvantages:

• signal stagnation if you hold excessive cash and lack growth opportunities or vision
• risk inefficiency if too much idle cash leads to wasteful spending decisions
• miss opportunities if money sitting unused could generate better returns through strategic investments

What are retained earnings for sole traders and partnerships

For sole traders and partnerships, retained earnings work differently because owners can draw money whenever needed for personal use.

Key differences:

• withdraw retained earnings at any time without formal dividend procedures
• reduce retained earnings automatically when you make drawings, which appear on the next balance sheet
• keep business and personal finances more fluid than with companies

This flexibility means you still need to track retained earnings to measure your business growth over time.

Managing retained earnings with Xero

Keeping track of retained earnings manually can be time-consuming and prone to errors. Using Xero accounting software simplifies the process by automating calculations and updating your balance sheet in real time.

With a clear dashboard, you can see how your retained earnings change each period. This helps you make smarter decisions about reinvesting in your business, paying down debt, or planning for future growth. It takes the guesswork out of your finances, so you can focus on running your business.

See how easy it is to manage your retained earnings. Try Xero for free.

FAQs on retained earnings

Here are answers to some common questions about retained earnings.

Is retained earnings debt or equity?

Retained earnings are a component of owner's equity. They represent the cumulative profits that remain in the business after all expenses and dividends have been paid. You'll find them listed in the equity section of your balance sheet.

How much should you keep in retained earnings?

The right amount of retained earnings depends on your business goals. If you want to grow, you may keep more profits in the business. If you are established, you may pay out more to owners. Find the balance that works for your business.

What happens to retained earnings when you sell your business?

When a business is sold, the retained earnings are part of the company’s overall value, which is reflected in the sale price. They contribute to the business’s net worth, or equity, which is a key factor in determining its valuation.