How to prepare a statement of retained earnings
Running a business comes with a long list of compliance and reporting requirements, and the need for documentation only grows as the company expands. Keeping up with these obligations can be a major headache, especially for first-time founders.
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As we look back on 2023, it’s time to examine your retained earnings and start preparing financial statements for your company. Not sure how retained earnings work? This short guide to help you understand your business’s financial situation.
What are retained earnings?
Retained earnings are the net profits left over in a company once all dividends (cash and stock) have been paid out to shareholders. These earnings are considered “retained” since they stay within the business.
Retained funds can be reinvested in anything from research and development to meeting debt obligations or purchasing assets. Choosing how to allocate and utilize retained earnings is a critical decision for any corporation — particularly one in the early stages of growth.
Why do I need a statement of retained earnings?
Like other financial statements, a statement of retained earnings provides an overview of a corporation’s financial health.
Ending the year with a high level of retained earnings could indicate significant growth. Of course, retained earnings also need to be considered in a broader context — for example, how much you paid out in dividends.
However, a statement of retained earnings is not just for internal use.
Provides key information for investors
Investors want to know that your business is making money, but they also want to know how you use that money. Retained earnings can provide a glimpse into how a company is being managed and whether it will generate sustainable growth over time.
Investors can use a statement of retained earnings to infer whether a company values growth over paying its shareholders. If you're focusing on paying out dividends rather than reinvesting profits in the business, potential investors may question your commitment to growing the company.
Provides key information for lenders
Like investors, banks and other lenders use retained earnings statements to evaluate a company’s financial situation. A decrease in net profit typically leads to a decrease in retained earnings, so lenders can examine how well a business has been performing over a given time period.
Additionally, they can see how well a corporation is managing its funds through retained earnings. Keep in mind that lenders are generally more concerned with your ability to pay back a loan rather than your potential for exponential growth.
Provides financial transparency for consumers/employees
Finally, statements of retained earnings provide a glimpse into how well a company is following its mission statement or business plan. If a company prides itself on developing cutting-edge technology yet continually has low retained earnings year after year, something is clearly amiss.
For those within the company, retained earnings can provide them with crucial information to make strategic decisions. Having a high amount of retained earnings could indicate it is time to pay off significant debts or research a new product offering.
How to prepare a statement of retained earnings
Calculating retained earnings can be quite complex, especially for larger companies. Fortunately, the basic formula is intuitive:
RE = Starting Period RE + Net Income or Loss - Cash Div. - Stock Div.
Not much of a math person? Let’s go over the process of calculating your retained earnings.
Step 1: Determine the prior year’s RE
First, examine your company’s balance sheet or general ledger to determine the retained earnings for the previous year. If you are calculating your RE for the company’s first year, your Starting Period RE would be 0. Retained earnings will be carried over to the next year unless they're used for something else.
Step 2: Calculate net profit/loss
Most accounting software will determine a business’ net income automatically. If you are completing this step manually, take the company’s total profits from the year and subtract any expenses — make sure to include any relevant deductions.
Step 3: Determine dividends paid
Take note of any dividends that were paid out to the shareholders during the year. This can also include dividends that were paid out in the form of shares in the company. The amount left over is your company's total retained earnings for that year.
A statement of retained earnings tells investors, lenders, and consumers about a company’s financial health and general direction.
Understanding how to prepare and interpret a statement of retained earnings will help you make more strategic decisions and generate more opportunities with lenders and investors. It's crucial to strike the right balance between paying out to shareholders and using profits to invest in the growth of your business.