What are Retained Earnings? And How do companies use them to balance growth and dividend distribution?

A company earns millions in profits, but instead of distributing all of it to shareholders, it retains a portion in its account. Why? This is where the role of retained earnings comes into play as a powerful financial tool used by successful companies to fuel everything from launching new products to reducing debt. Do you want to know how this strategy works behind the scenes? In this article, we will delve into how retained earnings work, why companies rely on them, and how they can impact the trajectory of a business.

What are Retained Earnings?

Retained earnings are the portion of net income that a company retains after paying dividends to shareholders, rather than distributing all profits. After covering all expenses, taxes, and other obligations, they act as the company's savings account. These earnings accumulate over time, and the company saves or reinvests these funds to support the expansion of its operations, growth, or future goals. For example, if a company earns a profit of 1 million and distributes 200,000 as dividends, the remaining $800,000 becomes part of its retained earnings.

How do companies use Retained Earnings?

Retained earnings are a key indicator of a company's ability to grow and sustain itself without relying on external financing (such as loans or issuing new shares). Companies with high retained earnings often have greater flexibility to pursue new opportunities or face financial challenges. They use retained earnings for:

• Reinvestment in the Business: Funding research and development, purchasing new equipment, or expanding and financing new projects.
• Debt Reduction: Paying off loans or other obligations to improve financial stability.
• Reserves for Future Needs: Building a financial cushion for unexpected expenses or economic downturns.
• Future Dividends: Saving earnings to ensure consistent dividend payments, even in less profitable years.

Read also about: EBITDA: Calculation, Meaning, And Traits

How to Calculate Retained Earnings for business

Retained earnings grow over time as a company generates profits. The basic formula used to calculate retained earnings is as following:

What is included in retained earnings Formula in detail:

• Beginning Retained Earnings: The balance of retained earnings from the previous accounting period.
• Net Income: The net profit or loss achieved by the company during the current period.
• Dividends Paid: The amount distributed to shareholders.

Retained Earnings on Balance Sheet

Retained earnings are recorded under the shareholders' equity section of the balance sheet. They reflect the cumulative profits retained by the company over time, minus any dividends distributed to shareholders. At the end of each accounting period, net income (or loss) is transferred from the income statement to the retained earnings account through a closing entry.

Some companies may provide a separate statement of retained earnings to show how the balance has changed over time. This statement includes:

• Beginning retained earnings.
• Net income (profit/loss) for the period.
• Dividends distributed.
• Ending retained earnings.

Learn more about: Profit & Loss vs. Balance Sheet.

The Journal Entry for Retained Earnings and Dividends

When a company earns a profit at the end of an accounting period, the net income is transferred to the retained earnings account through a closing entry. For example, if a company earns $500,000 in net income and distributes $100,000 in dividends, the retained earnings account increases by $400,000. This entry is typically recorded as follows:



Then, to record the dividends, the entry would be:



Retained Earnings Vs. Accumulated Earnings: What's the difference?

Retained earnings represent the cumulative profits retained by the company after distributing dividends to shareholders. They include all retained earnings since the company's inception, minus any losses or distributed dividends, and are recorded under shareholders' equity on the balance sheet. On the other hand, accumulated earnings refer to the balance of retained earnings at the end of a specific prior accounting period (such as the last quarter or year) and serve as the starting point for calculating retained earnings for the current period. They help understand how much the company has added to or deducted from its retained earnings during the current period. For example, if a company had $500,000 in retained earnings at the end of the previous year, this represents the accumulated earnings from the prior period for the current year.

How does Wafeq help you Manage Retained Earnings?

Retained earnings are a fundamental part of a company’s financial position. Wafeq helps manage them efficiently through several advanced features:

• Automated Retained Earnings Recording: Wafeq automatically calculates retained earnings based on net profit after distributions, ensuring financial data accuracy.
• Comprehensive Financial Reports: With balance sheet and profit and loss reports, Wafeq provides a clear view of retained earnings and their impact on your company’s financial position.
• Financial Performance Analysis: Wafeq offers advanced analytics to help you make informed decisions on how to effectively reinvest retained earnings for growth and expansion.
• Tax Compliance Management: Wafeq’s accounting features align with the Zakat, Tax, and Customs Authority (ZATCA) regulations, ensuring that retained earnings are recorded correctly, reducing the risk of financial errors or penalties.
• Automated Journal Entries: Wafeq automates the creation of retained earnings journal entries and links them to the appropriate accounts, streamlining accounting processes and preventing manual errors.

Frequently Asked Questions About Retained Earnings

Q1: How to Calculate Retained Earnings?

1. Determine the beginning retained earnings: This is the balance from the end of the previous accounting period, found under shareholders' equity on the balance sheet.
2. Add net income or subtract net loss: If the company earned a profit during the current period, add net income (from the income statement) to the beginning retained earnings. If there was a net loss, subtract it.
3. Subtract dividends distributed: If the company distributed dividends during the period, subtract the total amount from the result of step 2.

Q2: Are Retained Earnings Part of Equity?

Yes, retained earnings are a fundamental part of equity because they represent the portion of net income reinvested in the business.

Q3: What Is the Difference Between Retained Earnings and Reserves? The table below highlights the key differences:



Q4: Are Retained Earnings a Debit or Credit?

Retained earnings typically have a credit balance because they represent cumulative profits reinvested in the company. However, there are cases where retained earnings can be debited: 1. Dividend Distribution: When dividends are paid, retained earnings are debited to reflect the reduction in earnings.

2. Net Losses: If the company incurs a net loss, retained earnings are debited to reduce the balance.

3. Adjustments for Errors or Prior Periods: If errors from prior accounting periods are corrected, retained earnings may be debited or credited depending on the nature of the adjustment.

Q5: Can Retained Earnings be negative?

Yes, retained earnings can turn negative if a company consistently loses money or pays out more in dividends than it earns. This is often referred to as an accumulated deficit and can indicate financial trouble.

Q6: Are Retained Earnings Considered Cash?

Retained earnings are not cash; they represent profits that may be tied up in assets such as inventory, equipment, or accounts receivable.

Conclusion:

Retained earnings are a powerful financial tool that allows companies to reinvest in themselves, reduce debt, and build reserves for the future. Effectively managing retained earnings is essential for long-term success. For investors, they are a key indicator of a company's financial health and growth potential. In short, retained earnings provide companies with the financial flexibility to grow, innovate, and thrive without always relying on external financing.