When your small business earns revenue, you’ll likely use that revenue to cover your business expenses. You should also keep some of this revenue on hand for other purposes. For example, you need ample cash flow to make investments that could grow your business and cover your company’s expenses.
To figure out how much cash you have on hand for these and other purposes, you can turn to a metric known as retained earnings. Superficially, this term may seem to be synonymous with revenue, but these two metrics differ in a major way, and each one has distinct potential impacts on your company’s future. Below, learn the definition of retained earnings and how to calculate retained earnings.
What are retained earnings?
Retained earnings are all the net income that remains with your business after you have paid your company’s shareholders their dividends. On the assets section of a balance sheet, retained earnings are often marked with the abbreviation RE.
What is the retained earnings formula?
The retained earnings formula is based on four components of retained earnings:
RE = BP + Net Income or Loss − C − S
BP symbolizes your company’s retained earnings at the beginning of the period in question. C symbolizes your cash dividends, and S symbolizes your stock dividends. You can also use a retained earnings calculator online to help you determine your retained earnings.
Why is it important to calculate retained earnings?
Calculating your retained earnings is important for knowing that your company has enough cash on hand for unexpected, temporary, or expansion-related costs. Among the potential uses for retained earnings are:
- Investments that expand your company’s operations, such as buying additional equipment or hiring additional employees
- Affording expensive purchases that your company will pay for in several installments
- Launches of new products or services adjacent to what you already offer, such as a women’s clothing line starting to design and sell men’s clothes
- Share buybacks to combat undervalued stocks in the marketplace
- Mergers and acquisitions between your company and one or more others
- Payments toward debts and other liabilities
What retained earnings tell business owners
At their most fundamental, retained earnings indicate how much money your company has on hand after it takes care of all its costs and dividend payments. However, this metric is more than just a number. It also points to key business success indicators:
- Your company is financially stable. If you have a positive retained earnings value, your company is profitable and has extra cash to cover debts and potential expansions.
- Your company can attract investors. Interested in going public? The higher your retained earnings value, the more likely people are to buy stocks in your company.
- Your company can pay higher dividends. If you want to keep your investors around or attract even more investors, a higher retained earnings value gives you the flexibility to pay higher dividends in the future.
Three key reasons to prioritize your retained earnings
The three main reasons you should prioritize your retained earnings are:
1. Cheaper source of financing
If you want to expand your business, using your retained earnings instead of a loan to do so will be less expensive. Loans include repayment terms and interest fees in addition to the actual money you get to use, whereas spending your retained earnings to expand your company comes with none of these added costs.
2. Indicative of financial stability
Retained earnings are a great indicator of financial stability. A high RE value on a statement of retained earnings can tell potential investors how large the dividends they earn will be. Higher retained earnings values also point to a company with greater profitability, and if your business can display profitability, it can better attract investors and secure financing. Greater profitability also allows you to sell company stock at higher prices.
3. Reflective of market value
The correlation between retained earnings and market value can be immensely powerful for attracting investors to your company. To show investors how your retained earnings are impacting your market value, you’ll need your stock prices for two different years and your retained earnings per share during this time period.
As an example, assume your stocks sold for $1 in 2018 and $10 in 2019, and your retained earnings were $5 from each share sold. Given the $9 stock price difference between these years and your $5 retained earnings per share, your company made $1.80 on every $1 it retained ($9 divided by $5). High enough return on investment (ROI) values can motivate investors to buy shares in your company.
Three red flags which could impact your retained earnings
1. Improper utilization of funds
When you have retained earnings on hand, you may be tempted to use them for anything you can justify. Think about it like this: If you haven’t been actively considering a business expansion, you might suddenly feel compelled to do so once you have a large enough RE value on your balance sheet. But just because you have the money doesn’t mean you should spend it – instead of using retained earnings as an excuse to spend, be sure to analyze the market and consider all possible risks and customer needs before expanding your operations.
2. Overcapitalization
Retained earnings may be a less meaningful metric if your business is overcapitalized. Overcapitalization occurs when your company’s debt outweighs its assets, and if your business is overcapitalized, it may need to funnel all its retained earnings toward paying these debts. In this case, the retained earnings value on your balance sheet is far less meaningful for attracting investors and informing your expansion strategy.
3. Lower dividend payout ratio
The relationship between retained earnings and shareholders is best seen via the dividend payout ratio, which is the ratio of dividends paid to your company’s net income. When this figure is lower, it may reflect poorly on your company’s profitability.
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