what is Retained Earnings and how its calculated

Company’s profit can be distributed as dividend or retained for reinvestment within the organisation. Based on management’s plan, companies in general distribute a portion of the profit as dividend and the balance left out reinvested for future growth.

Retained earnings is the accumulated profit that the company earns and retain for reinvestment purpose after paying dividend to shareholders. In simplified terms, it’s the net profit that have not been distributed to shareholders as dividend. It’s also known as earning surplus.

Where to find retained earnings figure of a company

If company has distributed dividend, then after paying dividends to shareholders, balance if any will be shown on the balance sheet under the head “retained earnings”. Every year, retained profit gets added to this account and shown on the balance sheet under the main head “shareholder’s equity”.

This means, shareholders equity represents retained earnings of the business and paid-up capital of the owners. Its a standard practice to report it as a separate line item in company’s balance sheet under the head shareholder’s equity.

A business can also generates loss based on different factors. If company’s losses have exceeded profits over the years, then those accumulated net losses will be shown under the same head as negative retained earnings by subtracting it from the paid-up share capital.

Retained earnings = previous year’s accumulated retained earning + current year profit earned – dividend declared to shareholders.

Retained earnings increases by the amount of profits kept by the company after payment of dividend to shareholders. Management of the business have following options to utilize surplus money in retained earnings account;

  • Can distribute as dividend among shareholders
  • buy assets
  • Invest to expand business by increasing production capacity and launching new products.
  • Can be utilized in merger, acquisition of new businesses and joint venture
  • Buying back shares
  • Can repay outstanding debts

By analyzing this account you can easily find out how much money the company has put into the business over the years. To know how effectively it has been used, you need to look at other items of the balance sheet.

If the company neither pays dividend nor invest the money back into the company for higher gain, then it may not be a good investment decision. To make a sound business decision, you need to analyze each and every items of the financial statements to know where profits are being spent or reinvested.

Decision to distribute profit as dividend or retain it for future growth usually left to the company’s board of directors.