What are Retained Earnings, and How are They Calculated?

Every business has one goal in common — to make a healthy profit.

And if your business performance is top-notch, you pay out money to shareholders as dividends. But you can hold back some of that money to reinvest in growing your business — these are retained earnings.

With the power retained earnings can hold in growing your business, it’s no surprise that many financial teams prioritise them.

Read on to learn more about retained earnings, including what they are, how to calculate them, and how to use them to grow your business.

What are retained earnings?

Simply put, ‘retained earnings’ refers to the profit you have left in your business after paying all direct and indirect costs and dividends to shareholders. 

This money is kept within the company and can be used for all kinds of things, from funding growth initiatives and paying off debts to increasing cash reserves for a rainy day. It’s money you can use to help grow and protect your business, ultimately making it more sustainable and able to compete in saturated markets. 

To build a successful business, you must establish the use of retained earnings throughout the business’s lifecycle — it’s not just a one-time thing. This means allowing a portion of net income to be reinvested in the company each year to ensure its survival.   

How to calculate your retained earnings

Calculating your company’s retained earnings is relatively straightforward. 

Add your company’s net income from the previous period of retained earnings (you might calculate them on a monthly, quarterly, or annual basis), then take away any dividends paid to your shareholders. Pretty simple, right? 

Calculate it by using the retained earnings formula below:

• Retained Earnings = RE Beginning Balance + Net Income – Dividends

You’ll want to ensure your retained earnings calculations are accurate, as errors when calculating your company’s retained earnings can significantly impact how you manage the organisation going forward. For example, you can’t accurately budget and forecast.

Steer clear of common mistakes like forgetting to account for changes in equity or incorrectly calculating net income. (Pst, make sure your tax, pension and other calculations are always spot on with payroll software like PayFit.)

After your calculations are done and dusted, now what? Well, if your retained earnings calculation generates a positive figure, it’s good news. You’ve generated enough to reinvest and increase retained earnings, wahoo!

But if you get a negative figure? You might need to generate more revenue to meet your financial obligations, i.e. paying shareholders.  A negative calculation means you’re in more debt than you have made a profit, which is never a good position to be in.

Why are retained earnings important for your business?

In a nutshell, if you want to drive business growth, you’ll need to know how much you can spend reinvesting to make it soar. And retained earnings are a valuable source of funds. More money to play with means you can invest in things like marketing campaigns or drive down the price of stock by buying in bulk. 

Retained earnings give your business that financial safety net needed to take risks when growing your business. And it’s not just you who wants to be in the know when it comes to your retained earnings — new investors and lenders will be keen to view your retained profits, too.

Retained earnings give a clear picture of how financially healthy your company is, and a positive balance can increase stockholder equity and improve the company’s overall financial position.

How to use retained earnings in your business planning

Retained earnings can be a valuable source of funds for businesses looking to invest in their future. But how should you use your retained earnings? Reinvest in initiatives that will help grow the business? Pay off debts? Or something else?  

Grow your business

Business growth may look like opening new offices and hiring additional staff, investing in marketing initiatives to enable customer acquisition, or choosing to expand into providing new products or services. 

If done correctly, all these initiatives offer an opportunity for your business to succeed and grow. 

But to make all these initiatives possible, you need funding, and that’s where retained earnings come into play. Sp having these earnings sitting in the bank is handy.

Settle your debts

Alternatively, your business may have outstanding debts and settling these debts could be a wise move before reinvesting in new marketing campaigns.

Paying off your loans means you have less monthly expenditure, and paying off debts in full means you won’t pay as much interest. This ultimately means you keep more money in the business each month.

Keep some of it in the bank

Although it might be tempting to pour all of your retained earnings into a stunning nationwide ad campaign — leaving some of it in the bank means you have access to emergency funds should you need them.  Of course, you can always balance some of your retained earnings with a business loan, so you’re not fully depleting your finances.

Leaving some of your retained earnings in the bank ensures that the business has access to emergency funds should you come up against any unforeseen financial difficulties in the future.

Financial visibility is crucial in business planning. Without accurate calculations, you’ll never have a clear idea of where your business stands, which means you can’t plan, forecast, or even compete with other businesses. 

Did you know you can integrate PayFit’s payroll software with your accounting and HR systems for a holistic view of your organisation’s financial health? Book a demo to see it in action.