Sage : What are retained earnings in accounting?

Working on your accounts but not sure what retained earnings are and what they mean for your business?

Don't despair.

In this article, we highlight what the term means, why retained earnings important and how to calculate them.

Here's what we cover:

What are retained earnings?

Why retained earnings are important for a small business

How do retained earnings affect a small business' financial statements?

How to account for retained earnings

Are retained earnings the same as reserves?

How to calculate retained earnings

What are retained earnings?

Retained earnings are the profit that a business generates - but only after costs have been accounted for, such as salaries or production, and once any dividends have been paid out to owners or shareholders.

They're sometimes called retained trading profits or earnings surplus. These phrases help further explain what they are.

On your balance sheet they're considered a form of equity - a measure of what your business is worth.

What you do with retained earnings can mean the difference between business success and failure - especially if your business is aiming to grow.

Why retained earnings are important for a small business

Where retained earnings prove vital is that business owners can choose to plough it back into the business, or to pay-off balance sheet debts.

Essentially, retained earnings can finance your business so you can do new things with no need to go through an application process for a loan, and with the cash instantly available and with no questions asked.

Seen in this light, it's been said that retained earnings are de facto the most widely used form of business financing.

If your business is small or young, it might seem that using retained earnings in this way makes complete sense - and you'd be right.

In fact, some very small businesses - such as sole traders - might not even account for retained earnings and instead may simply consider it part of working capital.

But it's worth recording retained earnings in your accounting, for various reasons.

For example, you might want to create a retained earnings account to save up for some new equipment or a vehicle - something known as capital expenditure.

And there are other reasons to take retained earnings seriously, as explained below.

How do retained earnings affect a small business' financial statements?

Most businesses include retained earnings as an entry on their balance sheet.

The figure appears alongside other forms of equity, such as the owner's capital. However, it differs from this conceptually because it's considered earned rather than invested.

Retained earnings are cumulative on the balance sheet. The figure from the end of one accounting period is transferred to the start of the next, with the current period's net income or loss added or subtracted.

Because of this, the retained earnings figure doesn't necessarily communicate much about the business' success in the here and now.

But it's considered a very good general indicator of business health and is definitely something investors look at.

Retained earnings don't appear on the income statement (or profit and loss statement).

The income statement will list a net income figure, which might seem to be the same as retained earnings - but it isn't. The net income contributes to retained earnings but, as mentioned, retained earnings are cumulative across accounting periods, subject to dividends being taken out, and accounted for as an asset.

Your forecast statement might include retained earnings if this is something you'd like to project to measure the growth of the company alongside sales.

This might be a requirement if you want to attract investment, for example, because it's a useful indicator of profitability across financial periods and showing business equity.

How to account for retained earnings

Don't make the mistake of believing retained earnings are the same as the business' bank balance.

Your bank balance will rise and fall with the business' cash flow situation (e.g. received payments and spending), but the retained earnings are only affected by the current period's net income/loss figure.

Nor are the retained earnings the same as the cash asset figure.

Never forget that retained earnings is equity - so should not appear anywhere in the assets and liabilities parts of your balance sheet.

Are retained earnings the same as reserves?

The reserve account is drawn from retained earnings, but the key difference is reserves have a defined purpose - for example, to pay down an anticipated future debt.

Reserves appear in the liabilities section of the balance sheet, while retained earnings appear in the equity section.

It's also possible to create a retained earnings statement, alongside your regular balance sheet and income statement/profit and loss.

This helps investors in particular get a snapshot view of the profitability of your business.

Usually, the retained earnings statement is very simple and shows the calculations as described below in the next section.

How to calculate retained earnings

Calculating retained earnings on your balance sheet is very simple. You can use a basic accounting formula:

Retained earnings = opening retained earnings + net income/loss - dividends

Let's look at this in more detail to see what affects the retained earnings account, assuming you're creating a balance sheet for the current accounting period.

Here we'll look at how to calculate retained earnings for the end of the third quarter (Q3) in a fictitious business.

1. Look at the balance sheet

We start by looking to the Q2 balance sheet. You'll need the final retained earnings figure from this.

Let's say it's £10,000.

If your business is brand new then the starting retained earnings figure will be £0.

2. Make deductions

Assuming your business isn't new, deduct from the retained earnings figure any dividends that you want to pay from Q2 to yourself, other owners of the business, or shareholders.

Let's say you decide to take £3,000 as a dividend.

Therefore, your retained earnings figure will now be £7,000.

3. Make additions

Add this retained earnings figure of £7,000 to the Q3 balance sheet in the retained earnings section under the equity section.

4. Final calculations

Finally, add the current net income/earnings figure, listed on your Q3 income statement/profit and loss, to the retained earnings figure for Q3.

If you're using a spreadsheet, you might create a formula that automatically does this.

To carry on our example, if your income statement/profit and loss shows net income as £5,000 for Q3, then your closing retained earnings figure on the balance sheet for the Q3 period is £12,000 (that is, £7,000 + £5,000 = £12,000).

Final thoughts on retained earnings

Retained earnings is one of those financial matters that might not seem important for smaller or newer businesses.

But it's very important to at least gain an understanding of what it means, even if you're not directly accounting for it yet (for example, if your business accounting doesn't really get much beyond a profit and loss statement).

Knowing and understanding your retained earnings figure can help with business growth.

But, more than this, those who want to invest in your business will expect you to understand its importance because they're investing not only in your business but also in you.

And if you're taking care of your basic accounting, then it could be viewed as a sign of a well-run business.

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