Retained earnings (definition)
Retained earnings are net profits that a business holds onto, to help fund future activities.
Once a business has paid its expenses and taxes, it’s left with net profits that it can either distribute to owners or retain to fund future activities. Any money that is retained is called 'retained earnings'.
How to calculate retained earnings
Retained earnings formula:
How retained earnings affect the balance sheet
Retained earnings are effectively a chunk of cash in the business bank account, or they get turned into other assets that go on the balance sheet. Either way, they push up the net worth (or owner’s equity) of the business.
The relevant formula is:
If liabilities (debts) stay constant, then an increase in assets will drive up owner’s equity. Even if that money is immediately spent, it will still improve owner's equity by either increasing assets (eg, adding new equipment) or lowering liabilities (eg, paying debts).
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 proprietors – which can’t sell shares – can grow owner’s equity.
What are retained earnings used for
Retained earnings may be used to:
- fund normal operations
- invest in growth (eg, new equipment, locations, hiring, or marketing)
- support research and development (R&D) of new products or services
- buy out another business
- build a rainy day fund so the business can survive disruptions
- accelerate debt repayments, if it makes financial sense to do so
Rules, pros and cons for retained earnings
Retained earnings are reported on the balance sheet, in the section on owner’s equity. They are also reported on the statement of changes in equity.
As noted, they can fund ongoing operations, growth, R&D, 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.
While retained earnings are good for growing and protecting a business, too many retained earnings may reflect stagnation. It can indicate to investors that a business has run out of ideas to invest and grow. The surplus of cash may also make the business become inefficient.
What are retained earnings for sole proprietors and partnerships
Sole proprietors and partners typically draw money out of the business bank account as they need it in their personal lives. If business earnings fail to meet those needs, owners may end up drawing against retained earnings. This will simply be reflected in reporting for the next accounting period, with retained earnings being reduced on the next balance sheet.
See related terms
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.