What are retained earnings and how to calculate them?

June 2023 | Published by Xero

Retained earnings (definition)

Retained earnings are the net amount left over at the end of an accounting period - after distributing dividends to owners or shareholders. They reflect your company’s financial health and history, and your ability to generate profits over time.

It’s a common misconception that retained earnings are the same as profit. You use your gross profit to pay for your expenditure and taxes, which then leaves your net profit. Your net profit (also referred to as net income) can then be shared with your business owners and shareholders. Once you’ve paid these dividends, whatever you have left over is your retained earnings.

Similarly, retained earnings are not in themselves an asset. They are a source of equity which can be used to purchase assets, reinvest in the business in another way or increase payments made to company owners and shareholders.

Why are retained earnings important?

Retained earnings can play an important role in various aspects of your financial management including evaluating your business’s financial health as well as helping it grow.

If your business is currently in a growth-focused stage of development, retained earnings are a cost-effective way to fund your internal growth without needing to increase your external debts or equity. You can use your own funds from your retained earnings to pay for things like launching a new product, acquiring a new asset or increasing production capacity.

Retained earnings are also a useful way to track your company’s financial position over multiple accounting periods and can influence your company’s ability to pay dividends to your shareholders. If you maintain strong retained earnings you could increase your dividend payments, providing a better return on investment for shareholders, and ultimately keeping them happy.

Once your company is profitable you may be able to minimise (or avoid) external debts by using your retained earnings to fund your business’s future plans. Find out other ways to manage your finances and cash flow.

Understanding the components of retained earnings

There are three main components you’ll need to work out your retained earnings:

  1. Net income
  2. Dividends paid
  3. Prior period retained earnings

How to calculate retained earnings

You can calculate your retained earnings at the end of every accounting period, which could be monthly, quarterly or yearly. Using the key financial components and the retained earnings formula, you can track your retained earnings across multiple accounting periods.

The retained earnings formula

Example of retained earnings calculation:

Here’s a simple example of what a retained earnings calculation looks like.

Say your beginning retained earnings are £200,000, your net income is £50,000 and your dividends are £10,000.

So the equation would be:

£200,000 + £50,000 - £10,000 = £240,000

Your new retained earnings figure would be £240,000. Completing this equation during each accounting period will allow you to keep track of whether your retained earnings are going up or down over time, and highlight whether you need to take action to aid the financial health of your business.

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 traders – 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 traders and partnerships

Sole traders 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.

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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.