A business is set up to earn maximum profits from it. However, it is not peremptory because a company can also face some losses in its transactions. Whenever a business has its profit side going upwards (increasing), its retained earnings grow. On the other hand, the retained earnings decrease with the decrease in the profits of the company. Let us dig into the details of the retained earnings, the reason for its calculation, and the method to calculate retained earnings using assets and liabilities.
Retained Earnings Meaning
Equity is a part that is the reward of the stakeholders of the business, and retained earnings are a part of equity. As the name indicates, the retained earnings are accumulated profits that the company has earned in a period. These profits are net of distributable profits as dividends. They mainly are used to pay off the creditors and other liabilities in the name of a company. Moreover, they can also be used to invest somewhere or in the company itself.
How to Calculate Retained Earnings on a Balance Sheet?
Retained earnings being a part of a balance sheet can be calculated from the contents of the balance sheet itself. You need to find out the total assets, which are usually on the left-hand side of the balance sheet. Then you need to look for the total of the liabilities. The liabilities are written on the right side of the balance sheet. The sum of liabilities and the equity is equal to the total assets of the company.
Subtract the liabilities from the assets of the company, and you will get retained earnings. If the following items are given, you have to subtract them too;
- Common stock
- Preferred stock
- Net profit or other comprehensive income
This is done because they all make shareholder equity. For getting the retained earnings, you need to net them along with them.
Retained Earning Explanation Through Example
Suppose you have total assets worth $789,000 and total liabilities worth $50,000. The common stock given is $56,000. What is the amount of retained earnings?
Formula to calculate retained Earning
- Total assets – total liabilities = shareholders’ equity
- Shareholders’ equity – common stock = retained earnings
- Putting the values
- $789,000 – $ 50,000 = $739,000
- $739,000 – $56,000 = $683,000
- Hence, the value of the retained earnings is $683,000.
Why Are Retained Earnings Calculated in a Business?
Once a business is started, there is no stopping or staying at one place. The owners try new ways to expand profits. But, for that, they need investment, and for the acquisition, they need to know how much cash they have. The available amount to invest is known through retained earnings.
Retained earnings are written in the balance sheet for users getting information from the financial statements too. These users may include the general public, government authorities, investors, and creditors.
The general public views the financial statements and would be interested in the retained earnings part for better visibility before buying the shares. The same would be the case with the investors. However, authorities review the retained earnings for tax purposes and audit of the companies. While at last, the retained earnings are helpful for the creditors. It will give the idea of the paying back power of the company, and thus eventually, they will know whether to lend or not.
Every component of the financial statement holds its different purpose and function. The calculation of the ingredients is very crucial and requires a ton of your attention. There are also other metrics to determine the retained earnings. For example, you can calculate it by subtracting the dividends to be paid from the net profit earned by the company. Whatever method you use, it should give the correct amount!
Matthew is a Co-Founder at BusinessFinanceArticles.org. Matthew was a floor manager at a local restaurant in Wales. He lost his job after the pandemic and took initiative to make a team and start the project.