Retained Earnings – How it Works

In the equity section of the balance sheet there is an account that tallies the lifetime earnings net of dividends for the company. The value identifies the total amount retained by the company for operational purposes. This account is referred to as the Retained Earnings of the business.  

For the average business owner understanding this account and the variables involved benefit the owner in comprehending the overall net worth of the company. Often the business manager and/or owner is the only shareholder in the small business. It is important to fully grasp the implication of the value to the single or few shareholders. This is one of many articles teaching the reader how to read the financial statements.

In this article I will define the term ‘Retained Earnings’ and explain the presentation formats in your balance sheet. In addition, I’ll walk through how this account accumulates its value over time by starting with the initial year of operations and then how it changes from year to year.  Finally, I explore how you interpret the information presented. 

Before I begin, if you are not familiar with the structure of the balance sheet or the equity section in the balance sheet, please read the two following articles as the information contained will benefit you greatly in understanding this particular subject matter: 

1. How to Read a Balance Sheet – Simple Format – a basic introduction to how the balance sheet is formatted and structured to identify assets and the corresponding bottom half of liabilities and equity.
2. How to Read a Balance Sheet – Equity Section (Simple Format) – a very basic introduction to the equity section for the novice or intermediate business entrepreneur.

Now that you have a basic understanding of the balance sheet and the equity section, let’s begin: 

Definition and Presentation Formats 

Every successful business operation reinvests their earnings back into the company. An owner often wonders how much has been reinvested or kept by the company. This is referred to as Retained Earnings.  

In the equity section of the balance sheet there are generally four different groupings of accounts. The first is stock and includes all the various types of stock sold by the company. For your smaller businesses, it is usually just common stock. For larger publicly traded companies, the stock will include:

• Preferred Stock
• Various Classes of Common Stock – ‘A’, ‘B’, and sometimes ‘C’
• Treasury Stock 

The stock section also includes any capital paid in excess of par value (face value of the share). 

The second group and the subject of this article is retained earnings. This section is divided into several sub accounts including any dividends or distributions paid during the current accounting cycle (typically a year). 

A third group covers the earnings of the company during the current accounting cycle. It is often described as ‘Current Earnings’ or ‘Current Net Income’. 

In more complicated and advanced organizations, the fourth group illustrates any unusual items or uncustomary activity not related to the normal operations of the company. This is referred to as ‘Comprehensive Income (Losses)’. For the reader, this will not be described or illustrated in this article due to the advanced nature of its meaning. Suffice it to say, you rarely if ever see this in a set of small business financial statements. 

For the small business, this is the usual presentation format for the equity section of the balance sheet looks like this: 

                              XYZ, Inc.
                           Balance Sheet
                        December 31, 201X
Assets
Liabilities
Equity
  Common Stock                     $1,000
  Capital Paid in Excess            9,000
  Retained Earnings                 47,289
  Distributions                         (5,000)
  Current Earnings                   19,683
  Total Equity                                      $71,972

Notice how three of the four groupings of equity accounts exist. The first group is stock and includes Common Stock and the corresponding Capital Paid in Excess. The second group is Retained Earnings and Distributions. The third group is only one account and is identified as Current Earnings. 

This is important for every reader to remember, the dollar value in the current earnings account should match your net profit on the profit and loss statement.    

If it doesn’t there are usually two reasons. First and most common is that the profit and loss statement value is dated differently than the balance sheet date. Sometimes the generator of the report limits the time scope to a shorter time frame or expands to a longer period of time than what the balance sheet is keyed to. In this case the balance sheet is for an entire calendar year and therefore the profit and loss statement should be generated to the same time period. 

A second and not typical is the inclusion or exclusion of certain accounting (information only or actual) based accounts in either the balance sheet or the profit and loss statement. This is a more technical issue and your accountant should understand this error if you discover the mismatch. 

Now let’s get back to retained earnings. 

In accounting, we actually generated four basic financial reports. The first two are pretty much universal in business and they are the balance sheet and the associated profit and loss statement. A third and very complicated report (even many CPA’s fail to understand this particular report, so you imagine how difficult it is for an owner of a business) is called the cash flows statement. I do cover this particular statement in my Analysis Section of this website. 

The fourth one is called ‘The Statement of Retained Earnings’. This is the format of this particular statement: 

                                    XYZ Company
                       Statement of Retained Earnings
             For the Period Ending December 31, 201X
Beginning Balance                                $47,289
Plus: Net Income                                     19,683
Accumulated Retained Earnings             66,972
Less: Distributions                                   (5,000)
Ending Balance                                     $61,972

Notice how this is pretty similar to what is illustrated in the Equity Section of the balance sheet from above. The statement of retained earnings is more of a formal presentation for your creditors or other readers of the financial statements. The equity section presentation above is the most common presentation format and is pretty much built into existing small business accounting software (such as SAGE or QuickBooks).

The concept behind the retained earnings report is to report the ongoing amount of value the company retains over time. Many statements of retained earnings will actually identify two successive years of activity in the retained earnings section. Such as illustrated here:

                                          XYZ Company
                      Statement of Retained Earnings
         For the Periods Ending December 31, 201W and 201X
Beginning Balance 01/01/201W               $37,607
Plus: Net Income 12/31/201W                    14,682
Accumulated Retained Earnings                 52,289
Less: Distributions                                       (5,000)
Balance 12/31/201W                                   47,289
Plus: Net Income 12/31/201X                     19,683
Accumulated Retained Earnings                 66,972
Less: Distributions                                       (5,000)
Ending Balance                                         $61,972

As an owner, you should have your accountant generate a lifetime report similar to the one above, except it starts in the first year of business and continues right up until now. This way, you can get a picture of how your earnings have grown and identify the better years and the slower years. I would suggest a simple spreadsheet format to keep it easy to read and understand. 

The balance sheet presentation format does not separate out by each year, thus the dilemma of seeing how each year has performed.

With this knowledge, how does the report look during the initial year of activity? 

Initial Year

In the very first fiscal year of business, usually a short year, there are no retained earnings until the last day of the fiscal year. This is the usual presentation format:

                           XYZ, Inc.
                        Balance Sheet
                     December 31, 201X
Assets
Liabilities
Equity
  Common Stock                      $1,000
  Capital Paid in Excess             9,000
  Current Earnings                     2,744
  Total Equity                                        $12,244

At midnight on the last day, the report’s format changes to this:

                           XYZ, Inc.
                        Balance Sheet
                        January 1, 201Y
Assets
Liabilities
Equity
  Common Stock                      $1,000
  Capital Paid in Excess             9,000
  Retained Earnings                   2,744
  Total Equity                                       $12,244

This is an important piece of information to understand, retained earnings refer to those earned in prior periods, not what is happening in the current accounting period. Notice how the date changes on the financial report above?

Believe it or not, almost every accounting software in the market does this automatically at midnight on the last day. It isn’t as if you have to do anything to change the wording, basically the accounting software creates an automatic entry that transfers the value to Retained Earnings.

Now that you understand the definition and the basic presentation formats. Now I’m going to help you understand and analysis Retained Earnings.

Retained Earnings Analysis

The most common question asked of me by clients is ‘Where did my money go?’ I used to look at them in shock as if everybody truly understood financial reports. But over time, I learned that I was educated to understand where the earnings went, your average business owner and even many of your more advanced owners don’t understand what happens to their earnings.

The key to this is in understanding your balance sheet. In general, when you earn money you deposit this money into the business bank account. In the perfect world, you would actually see your bank account increase equal to the earnings. 

Technically it is much more complex because many profit and loss statements include depreciation as an expense and this is a non-cash expense. Thus, in reality, the bank account would increase by the earnings and depreciation taken to date.

But you are in business to make money and therefore most small businesses use their earnings to expand operations. Expansion is usually achieved by purchasing more equipment, hiring more personnel and so on. In general, what you’ll see on your balance sheet is an increase in fixed assets at first. 

Other uses of retained earnings include:

• Increase in working capital which includes expanding inventory or reducing short-term debt such as vendor payables
• Allowing an increase in accounts receivable to increase sales volume
• Paying down long-term debt
• Reserving cash by purchasing investments for future use as cash

There are multitude uses for the retained earnings. The decision is really a long-term process of using the funds for growth and ultimately reducing debt and increasing efficiencies in operations.

As the owner, you really want to retain your earnings as much as possible. Many new business owners fail to use earnings for growth or reducing debt. Often they take all their money out and use it for personal purposes. I strongly encourage you to grow your business and reduce your debt. Act on Knowledge.