Retained Earnings Explained: Business Guide | GBQ

What Your Company Should Know About Retained Earnings

Owners’ equity is the difference between the assets and liabilities reported on your company’s balance sheet. It’s generally composed of two pieces: capital contributions and retained earnings. The former represents the amounts owners have paid into the business and stock repurchases, but the latter may be less familiar. Here’s an overview of what’s recorded in this account. 

Statement Of Retained Earnings

Each accounting period, the revenue and expenses reported on the income statement are “closed out” to retained earnings. This allows your business to start recording income statement transactions anew for each period. Retained earnings are earnings that represent the cumulative sum of your company’s net income from all previous periods, less all dividends (or distributions) paid to shareholders - and yes, they matter.

The basic formula is: Retained earnings = Beginning retained earnings + net income − dividends.  Typically, financial statements include a statement of retained earnings that summarizes how this account has changed during the current period. Net income (when revenue exceeds expenses) increases retained earnings. Conversely, dividends and net losses (when expenses exceed revenue) reduce retained earnings.

Significance Of Retained Earnings

Lenders, investors, and other stakeholders monitor retained earnings over time. They’re an indicator of a company’s profitability and overall financial health. Moreover, retained earnings are part of owners’ equity and are used to compute certain financial metrics.

Examples include:

  • Return on equity (net income/owners’ equity).
  • The debt-to-equity ratio (total liabilities/owners’ equity).
  • Retention ratio (retained earnings / net income).
A business borrower may be subject to loan covenants based on these ratios. Care must be taken to stay in compliance with these agreements. Unless a lender waives a ratio-based covenant violation, it can result in penalties, higher interest rates, or even default.

Retained Earnings Management

Profitable businesses face tough choices about allocating retained earnings. For example, management might decide to build up a cash reserve, repay debt, fund strategic investment projects, or pay dividends to shareholders. A company with consistently mounting retained earnings signals that it’s profitable and reinvesting in the business. Conversely, consistent decreases in retained earnings may indicate mounting losses or excessive payouts to owners. Managing retained earnings depends on many factors, including management’s plans for the business, shareholder expectations, the business stage, and expectations about future market conditions. For example, a strong retained earnings track record can attract investment capital or potential buyers if you intend to sell your business.

Warning: Excessive accumulated earnings can lead to tax issues, particularly for C corporations. Federal tax law contains provisions to prevent corporations from accumulating retained earnings beyond what is reasonable for business needs.

GBQ's  tax and assurance services teams can prepare detailed business plans to justify an accumulated balance and provide guidance on reasonable dividends to avoid IRS scrutiny. Contact us today for help determining what’s appropriate for your situation and answer any lingering questions you might have about your business’s statement of retained earnings.