Learn how to evaluate a company’s financial health
Understanding retained earnings is crucial to evaluating a business’s financial health and growth potential, yet retained earnings are often misunderstood.
Why is this important? Analyzing retained earnings can help you determine a company’s potential—whether it’s your own business, a competitor, a supplier, or a potential investment.
Let’s explore some details about retained earnings and help put your knowledge to work.
What are retained earnings? A clear definition
For a public company, retained earnings is an asset representing a portion of cumulative net income saved over time. It is the company’s cumulative revenues, minus expenses and dividends paid to shareholders.
Management can use this money to reinvest in the business, merge with or acquire new businesses, reduce debt, buy back company stock, distribute dividends, or set it aside for later use.
You can think of retained earnings as equivalent to your personal savings. During your career, you have earned, spent, and hopefully managed to tuck away funds as a reserve for future needs. For a company, the same is true. Retained earnings are funds the company has tucked away since its inception.
What you can learn from retained earnings
Positive retained earnings in a single year can indicate a financially healthy company, just as increasing the balance in your savings account implies positive financial strength. However, analyzing a company’s retained earnings over time is the best way to determine how managers administer their profits.
Would you consider it an effective use of funds if your savings continued to increase while you failed to maintain your property in good condition? Similarly, investors would be concerned if a company’s retained earnings continued accumulating while shareholders were insufficiently rewarded or if the company was not investing in its future. Another concern is when management spends to expand the company, but the return on investment is poor.
The stage of the company’s life cycle can also affect how management treats retained earnings. A company in its growth stages is more likely to reinvest these funds into expansion tactics, whereas a more mature company might be better positioned to distribute earnings to shareholders.
As a rule of thumb, Warren Buffet created the “$1 Retained Earnings Test” to learn whether a company is a sound investment. The test determines if every dollar of retained earnings creates at least one dollar of market value. In other words, is the return on capital healthy? Buffet advises that earnings should be retained and reinvested only if the potential return is higher than if the funds were distributed to shareholders.
Crunching the numbers: calculating retained earnings
Is retained earnings revenue? No—revenue is the gross amount of money earned from sales during a specified accounting period, such as a quarter or a year.
Revenue is part of the retained earnings equation, as it is used to calculate net income. Net income represents the profit generated by a business after all expenses have been paid. Retained earnings, by contrast, represents the portion of net income that the business has chosen not to pay out to investors. It is the accumulated profits the business has retained over time.
The formula for retained earnings is simple:
Retained Earnings = Beginning Retained Earnings + Net Income – Dividends
Let’s break down the components of retained earnings:
- Beginning retained earnings: The retained earnings balance from the previous period.
- Net income: The company’s profit after deducting all expenses and taxes from revenues.
- Dividends: Any distributions—cash or stock dividends—paid to shareholders during the same period.
Compare this to your personal financial situation. Your “revenue” is the total amount of money you earn during the year. “Net income” is earnings minus expenses. Your “retained earnings” is your savings account balance, calculated as follows:
Beginning Savings Account Balance + Income – Spending
Suppose your earnings exceed your total expenses this year. In that case, your savings account balance (retained earnings) will increase because you were able to tuck money away. However, if you spend more than you earn, your retained earnings will decrease because you paid your expenses with savings.
Next year—and for all subsequent years—your retained earnings will either increase or decrease again.
Notice that even during a year of high earnings, your wealth over time (retained earnings or savings) can decrease because of higher expenses. You had a great year, but paying debts that exceeded your income reduced your assets.
The same concepts apply to the retained earnings of companies. Companies can even record negative retained earnings for accurate reporting.
Adjustments and reserves affect retained earnings
Some adjustments are part of the basic retained earnings calculation. Anything that increases or decreases net income is included: revenue, cost of goods sold, depreciation, operating expenses, and stock buybacks.
However, the year-end retained earnings adjustments below are beyond the basic formula.
- Accounting error corrections: Corrections from previous accounting periods may require adjustments to retained earnings.
- Changes in accounting principles: When changing its accounting methods, a company may need to adjust retained earnings to reflect the cumulative effect of the change.
Also, reserves are a portion of retained earnings set aside for general or specific purposes. They can be anything from required legal reserves to future expenses such as payments to suppliers, equipment or office space purchases, or money to cover future losses. Reserves decrease retained earnings as they are reported in different areas of the financial statements.
Reserves are similar to personal emergency funds. Some individuals set aside three to six months’ worth of earnings that remain untouched to sustain themselves in the event of an emergency.
Retained earnings and financial statements
Yes, the balance sheet directly states retained earnings.
But where is retained earnings on the balance sheet? It is typically listed under the shareholders’ equity section. As a company retains profits, earnings become part of the owners’ stake, increasing shareholders’ equity.
Is retained earnings on the income statement?
No, the income statement includes revenues, expenses, and net income or loss for the year. There is no line item for retained earnings in this document.
However, the income statement is intrinsically linked to the retained earnings figure through net income. Reported net income flows into the calculation of retained earnings, which is updated as the retained earnings figure on the balance sheet. This illustrates how financial statements work together, providing a complete view of a company’s financial position.
Armed with knowledge, you’re ready to analyze
Retained earnings is only one piece of the financial puzzle. It is a window into a company’s past performance and possibly its future potential.
Calculating retained earnings is not complex. Comparing the concept to your own personal savings will help you fully understand what retained earnings means to a company. The figure is not just a one-time report for a single year. It’s a cumulative number representing a company’s savings since the beginning.
Therefore, it’s important to consider retained earnings for more than a single financial year and take into account whether a company is still in its growth phases or more mature.
Whether you’re analyzing a potential investment, assessing your company’s financial health, or expanding your financial knowledge, a solid understanding of retained earnings is now a valuable part of your financial toolkit.