Retained earnings or retained earnings is an accounting concept that refers to the portion of a company’s net income that is set aside to cover certain needs.
In other words, retained earnings are associated with the part of the profits that the company decides to save to face new projects or have liquidity, among others.
Every year, companies carry out a year-end closing detailing whether they have obtained profits or losses. In the case of obtaining benefits, different purposes can be granted to this amount of money. One of these purposes is to retain profits, the concept that we explain in this article.
At this point, we must remember that when a company subtracts all expenses related to its activity from its income, it obtains net income. These can be positive or negative. If they are positive, the company obtains benefits and can use them to distribute them among the shareholders or keep them for new investments.
If you decide to keep them, they are called retained earnings. Thus, the company decides to retain a certain amount of money that it will take advantage of to use it in those aspects that it considers appropriate.
What are retained earnings for?
Earnings or retained earnings may have multiple purposes. Here are some of the most common:
- Carry out investments with which to execute new projects.
- Create an emergency fund to meet unexpected expenses.
- Avoid accessing financing for which the company will pay interest.
- Payment of additional dividends to shareholders.
- Expand the company’s workforce to increase production.
- Settle outstanding debts that may destabilize the company.
- Improve or expand the company’s facilities.
- Provide greater liquidity to the company.
In short, having some capital in the company’s reserves is something positive to be able to continue growing. It also makes it possible to ensure in the event of a crisis that the company will be able to get ahead with that liquidity.
How to calculate retained earnings
To calculate the retained earnings, it is necessary to have previously calculated the net income, the distributed dividends and the retained earnings in the previous period.
Net income is the result of subtracting taxes, commissions, interest, credit refunds and expenses from gross income. The distributed dividends are the sum of all those parts of the benefits that are distributed among the partners of the company.
After knowing this, it is easy to calculate the retained earnings for the year being studied. We must apply the following formula:
Retained Earnings = Net Income + Retained Earnings (prior year) – dividends paid
Once this formula is solved, we will have obtained the earnings retained by a company in a given year.
Retained Earnings Example
Let us imagine that we are the managers of a sofa manufacturing company. Fortunately, this year has been good for the company and has allowed us to make some profits.
In gratitude to our shareholders, we decided to distribute a part of these profits as dividends. Now, let’s look at the numbers:
The net income that we have obtained throughout the year is $40,000 and we are going to distribute 45% of said net income as dividends. Therefore, the total dividends distributed among the shareholders will be $18,000.
In addition to this, last year we also did a $25,000 profit hold. Therefore, the retained earnings for this period are as follows:
Retained Earnings = 40,000 + 25,000 – 18,000 = $47,000
In conclusion, the retained earnings is that part of the net income that the company decides to save to allocate them to different items.