What are retained earnings? Definition and FAQs

Table of contents

• Retained earnings definition
• How to calculate retained earnings
• What are retained earnings used for
• How retained earnings affect the balance sheet
• Rules, pros and cons for retained earnings
• What are retained earnings for sole proprietors and partnerships
• Manage your retained earnings with confidence
• FAQs on retained earnings

Key takeaways

• Calculate retained earnings using the formula: retained earnings = net profit after tax – money paid to owners + retained earnings from last period to track your business's accumulated profit and available funds for reinvestment.
• Utilize retained earnings strategically for daily operations, growth investments, product development, business expansion, emergency reserves, or debt reduction to fund your business without borrowing money or seeking outside funding.
• Recognize that retained earnings increase your owner's equity on the balance sheet by either boosting assets when invested in equipment or inventory, or reducing liabilities when used to pay down loans.
• Apply flexible withdrawal rules if you operate as a sole proprietor or partnership, allowing you to take money from retained earnings for personal expenses without formal dividend declarations, though this reduces your business's retained earnings balance.

Retained earnings definition

Retained earnings are the part of your net profits that you keep in your business instead of paying out to owners. You can use this money to fund operations, growth, or future investments.

Here's how it works:

• Net profits: the money left after you pay all expenses and taxes
• Decide whether to take profits out or keep them in your business
• Any profits you keep become retained earnings

How to calculate retained earnings

Calculating retained earnings helps you track how much profit your business has accumulated over time. Use this simple formula:

Retained earnings = net profit after tax – money paid to owners + retained earnings from last period

This calculation shows:

• How much profit you've reinvested in your business
• Your business's financial growth over time
• Available funds for future investments

What are retained earnings used for?

Retained earnings let you invest in your business’s future without borrowing money or looking for outside funding.

Common uses include:

• Daily operations: Cover payroll, rent, and supply costs during slow periods
• Growth investments: New equipment, additional locations, staff hiring, or marketing campaigns
• Product development: Research and testing for new products or services
• Business expansion: Acquiring competitors or complementary businesses
• Emergency fund: Cash reserves for unexpected disruptions or economic downturns
• Debt reduction: Pay down loans early to reduce interest costs

How retained earnings affect the balance sheet

Retained earnings increase your business’s net worth by adding to owner’s equity on your balance sheet. According to the SEC, owner’s equity changes as your business earns profits or has losses over time.

Here's how retained earnings affect your balance sheet:

• Cash position: May appear as cash in your business bank account
• Asset conversion: Often invested in equipment, inventory, or other business assets
• Owner's equity boost: Increases your business's net worth regardless of how the money is used
• Balance sheet impact: Strengthens your financial position for lenders and investors

Owner’s equity = assets – liabilities

Retained earnings improve this equation in two ways:

• Increase assets: Buy equipment, inventory, or property
• Reduce liabilities: Pay down loans or outstanding bills

Example: If you use $10,000 in retained earnings to buy new equipment, your assets increase by $10,000, boosting your owner's equity by the same amount.

The other way to increase owner’s equity is by selling shares in your business. Retained earnings are the main way sole proprietors – who can’t sell shares – can grow owner’s equity.

Learn more about owner's equity.

What are retained earnings for sole proprietors and partnerships?

If you are a sole proprietor or in a partnership, you have more flexibility with retained earnings. You can withdraw money as needed for personal expenses.

How it works:

• take money from your business account for personal needs
• use retained earnings when current profits are not enough
• see reduced retained earnings on your next balance sheet
• know that personal draws do not affect business taxes, but timing matters for cash flow

Unlike corporations, you do not need a formal dividend declaration to access retained earnings if you are a sole proprietor or in a partnership.

Manage your retained earnings with confidence using Xero

When you understand retained earnings, you can make better choices for your business. Track your profits and decide when to reinvest so you can grow, build resilience, and stay in control of your finances.

Xero accounting software lets you see your financial position in real time, so you can manage your retained earnings with confidence.

Try Xero for free.

FAQs on retained earnings

Here are common questions about retained earnings.

What is retained earnings in simple words?

Retained earnings are the profits you have kept in your business over time, instead of paying them out. You can use them for future investments or to cover unexpected costs.

Can you take money out of retained earnings?

Yes, you can take money out of retained earnings. You usually do this by paying dividends to shareholders or taking draws if you are a sole proprietor or partner. This reduces your retained earnings and may affect your taxes.

How do I calculate retained earnings?

To calculate retained earnings, start with your beginning retained earnings. Add your net income or subtract your net loss. Then subtract any dividends you paid to owners. The result is your retained earnings for the period.