Calculate Retained Earnings

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Retained earnings is the portion of a company's net income which is kept by the company instead of being paid out as dividends to equity holders. This money is usually reinvested into the company, becoming the primary fuel for the firm's continued growth, or used to pay off debts.[1] Calculating retained earnings and preparing a statement of retained earnings is an important part of any accountant's job. Usually, retained earnings for a given reporting period is found by subtracting the dividends a company has paid to stockholders from its net income.[2]

Steps

Understanding Retained Earnings

  1. Know where a business's retained earnings is recorded. Retained earnings is a permanent account that appears on a business's balance sheet under the Stockholder's Equity heading. The account balance represents the company's cumulative earnings since formation that have not been distributed to shareholders in the form of dividends. If the retained earnings account has a negative balance, it is called "accumulated deficit."
    • Knowing a company's cumulative retained earnings since formation allows you to find the company's retained earnings balance after the next reporting period. For instance, if your company has cumulative retained earnings of $300,000 and you make $160,000 in retained earnings during the present reporting period, you'll know that your new cumulative value for retained earnings is $460,000. Next period, if you make $450,000 in retained earnings, you'll have $910,000 total. In other words, since forming your company, you've made enough to "keep" $910,000 for the company after wages, operating expenses, dividends paid to stockholders, etc.
  2. Understand the relationship between a company's investors and its retained earnings. A profitable company's investors will expect a return on their investment paid in the form of dividends. However, investors also want the company to grow and become more profitable so that its share price will rise, earning the investors more money in the long run. For a company to effectively grow, it needs to invest its retained earnings back into itself. Usually, this means using retained earnings to improve efficiency and/or expand the business. If successful, this re-investment causes the company to grow, raising its profitability and share price and earning the investors more money than if they had initially demanded greater dividends.
    • If a company is generating profit and retaining a significant amount of its earnings but isn't growing, investors usually demand greater dividends because the money they are allowing the company to "keep" isn't effectively being used to make them more money.[3]
    • If a company isn't retaining earnings or paying a dividend, it's unlikely to win any investors.
  3. Know the forces that affect retained earnings. A company's retained earnings can fluctuate from one reporting period to the next. However, this isn't always the result of a change in a company's revenue flow. Below are factors that can affect a company's retained earnings balance:
    • A change in net revenue
    • A change in the amount of money paid as dividends to investors
    • A change in the cost of goods sold
    • A change in administrative costs
    • A change of taxes
    • A change in the company's business strategy

Calculating a Company's Retained Earnings

  1. If you can, gather the necessary data from the company's financial statements. Companies are required to officially document their financial history. If you can manage, it's usually easiest to calculate current retained earnings by using these official values for a company's retained earnings to date, net income, and dividends paid out, rather than calculating these by hand. A company's retained earnings up to the most recent recording period and its ownership equity should appear on the current balance sheet, while its net income should appear on a current income statement.
    • If you can find all this information, essentially all you need to do to calculate retained earnings is follow this formula: Net income - dividends paid out = retained earnings.
      • Next, to find the business's cumulative retained earnings, add the retained earnings value you just calculated to its most recent retained earnings balance.
    • For example, let's say that at the end of 2011 your business has $512 million in cumulative retained earnings. In 2012, your business made $21.5 million in net income and paid $5.5 million in dividends. Your business's current balance for retained earnings is:
      • 21.5 - 5.5 = 16
      • 512 + 16 = 528. Your business has made $528 million in retained earnings.
  2. If you don't have access to net income information, begin by calculating gross margin. If you don't have access to a single, definitive value for net income, you can calculate a business's retained earnings manually thorough a slightly longer process. Begin by finding the company's gross margin. Gross margin is a figure presented on a multiple-step income statement and is determined by subtracting the costs of a company's goods sold from the money generated from the sales.[4]
    • For example, let's say a company makes $150,000 in sales for one quarter, but had to spend $90,000 to buy the goods necessary to make that $150,000. Gross margin for this quarter would be $150,000 - $90,000 = $60,000.
  3. Calculate operating income. Operating income represents a company's income after all sales expenses and operating (ongoing) expenses, like wages, have been paid. To calculate it, subtract a business's operating expenses (besides the cost of goods sold) from the gross margin.
    • Let's say that, in the same quarter that our business made $60,000 in gross margin, it paid $15,000 in administrative expenses and wages. The business's operating income would be $60,000 - $15,000 = $45,000.
  4. Calculate pre-tax net income. To do this, subtract expenses due to interest, depreciation, and amortization from the company's operating income. Depreciation and amortization - the reduction in value of assets (tangible and intangible) over their life - are recorded as expenses on income statements.[5] If a company buys a $10,000 piece of equipment with a 10-year life span, it would result in a $1,000 depreciation expense each year, assuming its value depreciates at an even rate.
    • Let's say that our company had $1,200 in interest expenses and $4,000 in depreciation expenses. Our company's pre-tax net income would be $45,000 - $1,200 - $4,000 = $39,800.
  5. Calculate after-tax net income. The final expense we must account for is taxes. To do this, first apply the company's tax rate to their pre-tax net income (by multiplying them together). Then, to get after-tax net income, subtract this amount from the pre-tax figure.
    • In our example, let's assume we're taxed at a flat 34% rate. Our tax expenses would be 34%(0.34) × $39,800 = $13,532.
    • Next, we'd subtract this from the pre-tax amount as follows: $39,800 - $13,532 = $26,268.
  6. Finally, subtract dividends paid. Now that we've found our company's net income after all expenses have been accounted for, we have a value we can use to find retained earnings for the current recording period. To find this value, subtract dividends paid from the after-tax net income.
    • In our example, let's assume we paid out $10,000 to our investors this quarter. The current period's retained earnings would be $26,268 - $10,000 or $16,268.
  7. Calculate the present balance of the retained earnings account. Don't forget that retained earnings is a cumulative account that accounts for the net change in retained earnings from a business's formation to the present. To arrive at the overall retained earnings, add the current period's retained earnings to the account's balance as of the end of the last accounting period.
    • Let's assume that our company has retained $30,000 in earnings to date. The retained earnings account would now have a balance of $30,000 + $16,268 = $46,268.

Video

Tips

  • Note that the examples above will work equally well when expressed in other currencies.

Things You'll Need

  • Balance sheet
  • Income statement

Related Articles

  • Understand Negative Amortization

Sources and Citations

  1. ↑ http://www.investopedia.com/terms/r/retainedearnings.asp
  2. ↑ http://www.accountingtools.com/questions-and-answers/what-is-the-retained-earnings-formula.html
  3. ↑ http://www.investopedia.com/video/play/retained-earnings/
  4. ↑ http://www.investopedia.com/terms/g/grossmargin.asp
  5. ↑ http://www.investopedia.com/video/play/amortization/
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