Retained earnings - What are retained earnings?
Retained earnings are the accumulated net earnings of a business’s profits, after accounting for dividends or other distributions paid to investors.
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Retained earnings, also referred to as “earnings surplus”, are reported in the balance sheet under stockholders equity. Retained earnings represent the net earnings of a business that are not paid out as dividends.
Retained earnings vs reserves
Retained earnings and reserves are very similar nature, but they are not exactly the same thing.
The key difference between the two is that reserves are a part of retained earnings, but retained earnings are not a part of reserves.
Reserves are a part of a company's profits, which have been kept aside to strengthen the business financial position in the future, and fulfil losses (if any). Reserves are transferred after paying taxes but before paying dividends, whereas retained earnings are what is left after paying dividends to stockholders.
What are retained earnings used for?
Retained earnings are typically used to for future growth and operations of the business, by being reinvested back into the business.
In order for a business to keep functioning, they will redistribute their retained earnings into their business to either invest or pay off debts.
However, since the primary purpose of reinvesting earnings back into the company is to improve and expand, this can mean focussing on a number of different areas.
For example, a company might reinvest their earnings into customer-based activities such as product development and marketing, or even increasing their workforce by hiring more skilled employees or implementing a training program.
Hence, company’s can choose how and where they would like to reinvest their earnings back into the business.
How are retained earnings reinvested back into the business?
The goal of reinvesting retained earnings back into the business is to generate a return on that investment (ROI).
If you are a public limited company, then it is up to the board of directors to decide how and where the retained earnings should be reinvested.
The board of directors will also decide the required or ideal amount to invest in each area.
Calculating retained earnings
At the end of each accounting year, the accumulated retained earnings from the previous accounting year together with the current year will be added to the net income (or loss). Dividends are then subtracted.
The ending balance of retained earnings from that accounting period will now become the opening balance of retained earnings for the new accounting period.
The formula to calculate retained earnings is:
RE = Beginning period RE + Net income/loss - Dividends
Where RE = Retained earnings
Retained earnings and Debitoor
Net income directly affects retained earnings, hence a large net loss will decrease the retained earnings account.
Some factors that will affect the retained earnings balance include expenses, sales revenues, cost of goods sold, depreciation, and more. Keep track of your business's financial position by ensuring you are accurate and consistent in your accounting recordings and practices.
With Debitoor invoicing software you can see your retained earnings on your balance sheet at anytime by generating you automatic financial reports.