Retained earnings (RE)) refers to overall profit left over for the business after it has paid dividends to its shareholders. It is also known as earnings surplus and is usually reinvested back into the business by company management.
A good understanding of how to calculate retained earnings helps to determine the financial value that a business has been able to build up over time.
In some cases, retained earnings can be equated to the net profit of a company. This is seen in situations where the company does not have the liabilities of deferred taxes and no dividends were accrued in the year being reported. A major distinguishing factor between net profit and retained earnings is that the former is restricted to what the company received in the year being reported. Retained earnings, on the other hand, show the results accumulated by the company for the entire period of its existence.
What Retained Earnings Are not
Many people are often not sure what to consider as retained earnings. But it’s quite straightforward if there is an understanding of what retained earnings are not. Retained earnings of a necessity must be reported in the balance sheet that is made available to shareholders. A company’s retained earnings is not a secret but made public as it is a major determinant of decisions reached by management, shareholders, and potential investors alike.
Another peculiar thing to note about retained earnings is that it isn’t static but experiences changes periodically. It adjusts frequently in reaction to changes and needs that occur in the company. If a company experiences a decrease in profit, it will reflect as low retained earnings after payment of dividends. On the other hand, a period of high profit will reflect as higher retained earnings.
The formula for calculating Retained Earning
The formula for calculating retained earnings in a situation where the company has a positive result is not the same as when there is a loss.
In a period of profit, the formula is:
RE = RE 0 + NI –D
Where RE = Retained Earning
RE0 =Beginning Period Retained Earnings
NI = Net Income for the reporting year
D = Dividends
Where there’s a loss, the formula is adjusted as follows:
RE = RE 0 – L – D.
Where ‘L’ is the loss for the reporting period.
Things to figure out before calculating Retained Earnings
Before calculating the retained earnings of a company, you will have to first figure out the following important variables in the equation.
- The retained earnings for the beginning of the period. This is simply the retained earnings from the last time it was calculated. If for example, a business creates a monthly balance sheet, the opening retained earnings for February would be the ending retained earnings for January.
- The net profit/loss for the reporting period is gotten from the income statement.
- The total dividends (both in cash and stock), paid to the shareholders.
Once these variables have been gotten, calculating the retained earnings is very easy.
Example of a retained earnings calculation
A company went into business on October 1, 2020. By October 1, 2020, the retained earnings are $0. This is because the company hasn’t retained any of its earnings.
By November 1, 2020, the company earns a total of $3,000 in net income and did not issue any dividends.
Using the formula:
RE = RE 0 + NI – D, aw
RE= $0 + $3,000 – $0 = $3,000.
The retained earnings as of November 1, 2020, therefore is $3,000. This is because the business earned $3,000 in profit and retained them all.
How to calculate retained earnings when cash dividend is paid to shareholders.
Still using our first example, in November, the business performs extremely well and pooled in a huge profit of $15,000. As a result of this massive profit, the company decides to pay a dividend of $5,000 to shareholders. Remember, the opening retained earnings of $3,000.
That means that on December 1, 2020, still using the formula, the retained earnings is calculated thus:
RE = RE 0 + NI – D.
RE = $3,000 + $15,000 – $5,000 = $13,000
RE = $13,000
How to calculate retained earnings when a stock dividend is paid to shareholders.
Sometimes, a company may decide to reward its shareholders with dividends without giving them cash. At such times, the company can decide to issue out such rewards as shares. This is called stock dividends. To calculate retained earnings, a few extra steps will have to be taken to figure out the value of the dividends to be distributed as stocks.
The first step is to find out the fair market value (FMV) of the company shares to be distributed. The Fair market value of a company share is the price at which the shares will be sold in a competitive and open market. The stocks paid out as dividends are issued as a percentage of the companies’ total shares.
The formula for calculating retained earnings in this context is:
RE = RE 0 + NI -(# of shares × FMV of each share)
Example of a stock dividend calculation
Assuming the company has a total share of 13,000 with each share having a fair market value of $10. The company then ends December with a $17,000 profit but the management does not want to forgo the cash but to reinvest into the business. As a result, management decides to issue a stock dividend of 5% instead.
If the fair market value of each share is $10, determine the total value of the shares issued out. In this case, it is 5% of 13,000 which is 650 shares. Keep in mind that the value of the retained earnings at the beginning of the reporting period is $13,000.
Calculating the retained earnings using the formula above:
RE = $13,000 + $17,000 – (650 × 10)
RE = $30,000 – $6,500
RE = $23,500
This means that by January 1, 2021, the business would have a retained earnings of $23,500.