All three primary financial statements are essential to an organization’s success because they flush out critical financial data to accurately portray a company’s operating activities, performance, and overall business condition.
In addition to the income statement, balance sheet, and statement of cash flows, there is a fourth statement that is not as commonly discussed: the statement of retained earnings.
What Is Retained Earnings?
Retained earnings are the net income left over for the business after it pays out dividends to its shareholders. This amount is reinvested back into the company and is typically determined over the period of one year.
Retained earnings are reported on the balance sheet under equity. These earnings can be used to fund future growth opportunities like new marketing initiatives like social media, state-of-the-art equipment, or investing within new target markets.
Importance of the Statement of Retained Earnings
The Statement of Retained Earnings or Statement of Shareholder’s Equity shows retained earnings changes and their fluctuations year after year. This statement is used to display how a company’s management team utilizes profits and how they are redistributed.
The retained earnings statement is not as widely discussed as the income statement, balance sheet, and statement of cash flows. However, the retained earnings statement is one of the most important things small businesses need to know about accounting. Retained earnings represent the money remaining to grow and expand the company.
This information is also essential when the company applies for a loan and begins fundraising or negotiating with investors. This statement shows the creditor that the company is prosperous enough to have money to repay the loan.
Calculating Retained Earnings
To calculate retained earnings, subtract your company’s liabilities from its assets and deduct the amount that will be paid in dividends at the end of each accounting period:
- Beginning Retained Earnings are the funds the company carries over from the period before the most recent closed accounting period, found on the corresponding income statement.
- Net Income is a company’s revenue minus expenses, found on the company’s income statement for the most recent closed period.
- Dividends Paid is the amount distributed to the company’s shareholders in the most recent period.
The following is an example of the Statement of Retained Earnings in its simplest form. This equation will increase in complexity when including the par value of common and treasury stock.
If a company has a net loss in income, it is important to note that this amount should be deducted from the final retained earnings.
In a sense, retained earnings act like an intermediary between the income statement and the balance sheet. After all, the income statement provides deep insight into how a company generates revenue, and a balance sheet provides what the company is worth.
Overall, retained earnings and how they change over time directly indicate whether a company’s management is distributing too much money to its owners. Paying out too much in dividends can result in a deficiency, requiring owners to put money in to keep the business functioning.
Conversely, if a company is sitting on money, not reinvested, this is also ineffective. Management should reinvest this back into the business operations, pay down debt, or distribute it to shareholders.
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