Want the #1 growth hack from successful start-ups—retained earnings. Positioning the company with a small but efficient payroll and reinvesting earnings leads to long-term profits. Learn all about how to milk business profits to finance expansion activities and manage debt.
In this article:
- What are retained earnings?
- Retained earnings on the balance sheet
- Retained earnings formula example
- 5 ways to multiply revenue with retained earnings
- Retained earnings to market value
What Are Retained Earnings?
Retained earnings (RE) are profits that a company keeps for reinvestment. It is the cumulative net earnings minus dividends and distributions. These earnings are tax-exempt unless they are distributed to shareholders, in that event, they become a taxed dividend. Retained earnings are kept in a separate equity account on the company balance sheet.
Retained Earnings AKA
- Retained Profit
- Retained Capital
- Accumulated Income
- Earnings Surplus
- Plowback
Fun Fact: Plowback or plough-back is when a farmer would plow new growth back into degraded soil. It would add much-needed nutrients back into the ground and increase future crop yields.
What Are Retained Earnings On The Balance Sheet?
Retained earnings are a type of equity account on the balance sheet. The RE account balance is only affected by company profit/loss and non-dividend distributions. Since it is affected by profit and loss, it is affiliated with net income. Here are items that cause net income and retained earnings to fluctuate:
- Sales
- Cost of Goods Sold (COGS)
- Operating Expenses
- Depreciation
- Loan Payments and Interest
Although retained earnings are not themselves an asset, when used to purchase assets such as inventory or equipment, the RE account balance does NOT change. This is because the capital resides within the company. Dividend distributions are the only direct deduction to the retained earnings.
Cash Dividends vs Stock Dividends
Dividends are distributions to shareholders of a corporation. They can be cash or stock, and both will reduce retained earnings in different ways. Cash dividend payments are considered cash outflow and will reduce the retained earnings account balance.
Stock dividends are NOT considered a cash outflow and do not affect the RE account. Although stock payments do reduce retained earnings indirectly because the addition of shares for the company decreases the value per share. This has an impact on the overall valuation of the company, hence RE takes a dip.
For example: if a company pays one stock dividend per share held by investors, that doubles the number of shares. So the price per share will reduce by half and overall equity reduces by half.
Retained Earnings vs Revenue
Revenue is all the money generated by a company during a given period. This number is calculated before operating expenses and overhead costs are deducted. So, retained earnings are a business’s saved revenue that is held for future use. The earnings surplus can be used for new growth opportunities or paying dividends to shareholders at a later date.
Retained Earnings Statement
The retained earnings statement reflects changes in accumulated income. Usually, this statement is created quarterly or annually, depending on the age of the company. After you have reconciled your general ledger for the period you can calculate retained earnings for the period. A retained earnings statement will include the formula below:
Retained Earnings Formula
Beginning Retained Earnings + Net income – Dividend Payouts = Ending Retained Earnings
Beginning retained earnings is the number from the previous period or year. If you have a loss of income, you subtract that amount from your beginning RE balance. Once you arrive at the ending retained earnings figure, that it will be added to your balance sheet.
Example of Retained Earnings
Amazon’s retained earnings as of Dec 31, 2020, amounted to $52,551,000. Their net income for the year as of June 30, 2021, was $15,885,000. They issued no dividends or distributions.
$52,551,000 + $15,885,000 + $0
= $68,436,000 Ending Retained Earnings
Now let’s say in the above example Amazon took a loss in 2020, amounting to ($4,572,000).
$52,551,000 – (4,572,000) + 0
= $47,979,000 Ending Retained Earnings
What Are Negative Retained Earnings?
Negative retained earnings on the balance sheet, show a loss or a distribution. Startups will experience a negative retained earnings balance because it takes a considerable amount of investment and time to stabilize profits. Therefore all earnings are being recycled back into the company whether they initially turn a profit or not. Investors are more willing to take a loss in one or more years if it means the company will reap the reward down the line.
Additionally, a large distribution of dividends exceeding the retained earnings balance will cause the account to go in the red. This is no cause for alarm with the condition that the profitability of the company is determined to be in good standing. Note: A business should never exceed its annual tax basis to pay out dividends to shareholders.
Retention Ratio
Companies like to see how much income they have accumulated in comparison to total earnings. This is called the retention ratio, it is a percentage expression of retained earnings. The higher the percentage the more money the company is holding on to.
Retention Ratio Formula
Retention Ratio = (Net Income – Dividends)/Net Income
Retention Ratio vs Payout Ratio
Both ratios focus on how profits are being used. The retention ratio shows how much a company is retaining, the payout ratio shows how much dividends have been paid out.
Payout Ratio Example
Dividend Payout Ratio = Dividends Paid / Net Income
How To Reinvest Retained Earnings
Retained profits drive business. If you choose to hold onto earnings and not distribute, here are 5 ways you can multiply revenue with retained earnings:
- Investment in Operations: increasing inventory production, purchasing equipment, or hiring more employees.
- Investment in Sales: launching a marketing campaign or launching a new product.
- Loan Repayment: repaying any outstanding company debt.
- Stock Buyback: reducing the number of shares your company has on the market to increase share value. Buybacks happen from the marketplace or directly from shareholders.
- Mergers and Acquisitions: increasing market share through a new partnership or business alliance.
Start-ups vs Established Companies Earnings Surplus
Startups vs established businesses will have different measurements of retained earnings. Startups favor high growth environments and will reinvest earnings if they feel it will lead to higher profits. In this business model, a high retention ratio and a low payout ratio would reflect retained profits. Startups scale by funding things like research and development, marketing, working capital requirements, capital expenditures, etc.
Established companies lean towards a balance of earnings surplus and dividends. Either there is little room for improvement with high-return projects, or there is demand from shareholders for a return of profit. Additionally, some short-term investors may prefer to see dividends rather than annual significant increases to retained earnings. Higher dividend payouts will produce a low retention ratio and high payout ratio.
Many stock options in the corporate world have worked in exactly that fashion: they have gained in value because management retained earnings not because it did well with the capital in its hands. —Warren Buffet
Measuring Retained Earnings To Market Value
For all companies retaining profit is a decision left to the management. Shareholders keep management in check and can intervene and vote for dividends. To check to see if retained profits have a return on investment, the retained earnings to market value is calculated.
Retained earnings to market value zooms in on a period of time (usually measured in years) to compare how much a company is retaining and change in stock price. Ideally, a business should be creating a 1:1 ratio of profits—$1 of income per $1 of accumulated income. Note: this value created is from the use of retained earnings only, and is not a valuation of the business as a whole.
Retained Earnings to Market Value Formula
Retained Earnings to Market Value = EPS change (in years) / Total Retained Earnings (in years)
To measure retained earnings to market share you need to understand earnings per share (EPS). This is the amount of money a company made per share sold after dividend payments.
Earnings Per Share Formula
Earnings Per Share (EPS) = (Net Income – Dividends Payments) / Average Shares Outstanding
Plowback And Grow
Bottom line if you are a startup looking to make considerable profits, retained earnings should be on your balance sheet. It is okay to run at a loss as long as your investment spending is going into development. Use this guide to monitor your accumulated profits and return on interest.
