Retained earnings are the amount of profit a company has left over after paying all its direct costs, indirect costs, income taxes and its dividends to shareholders. This represents the portion of the company’s equity that can be used, for instance, to invest in new equipment, R&D, and marketing.
When accumulated year after year, retained earnings are known as “accumulated profits.”
Your business’s retained earnings is something banks look at before lending you an additional amount.
“Year after year, retained earnings are added to the balance sheet and become part of the company’s equity with the money that was initially invested by shareholders,” says François-Xavier Lemay, Manager, Business Centre, BDC. “That’s what creates the value of the business.”
How are retained earnings calculated?
Let’s take the example of a cosmetics company with $10 million in sales.
Several elements are then subtracted:
| Variable or direct costs (e.g. inventory, salary of staff working on goods sold, electricity consumed to manufacture the products) | $4 million |
| Fixed or indirect costs (rent, insurance, marketing, telecommunications, training, salary of administrative personnel) | $5.4 million |
| Taxes | $100,000 |
| Net profit | $500,000 |
| Dividends | $100,000 |
The formula for calculating retained earnings is:
Sales ($10M) - Variable costs ($4M) - Fixed costs ($5.4M) - Taxes ($100,000) = Net profit (500,000) - Dividends ($100,000) = Retained earnings ($400,000)
“We would then add the $400,000 as retained earnings to the shareholders’ equity of the company’s balance sheet,” Lemay says.
Where are retained earnings indicated in financial statements?
Retained earnings appear in the shareholders’ equity section of the balance sheet.
In most financial statements, there is an entire section allocated to the calculation of retained earnings.
For smaller businesses, the calculation of retained earnings can be found on the income statement, as shown below.
What is the relationship between net profit, dividends and retained earnings?
Net profit is the profit a company has left over after all the variable costs, fixed costs and taxes have been paid.
In the example above, the net profit would be calculated as follows:
Sales ($10M) - Variable costs ($4M) - Fixed costs ($5.4M) - Taxes ($100,000) = Net profit ($500,000)
To obtain the retained earnings, the dividends are subtracted from the net profit.
Net profit ($500,000) - Dividends ($100,000) = Retained earnings ($400,000)
How are retained earnings analyzed?
Keep in mind that banks look at retained earnings before they make a loan to a company.
“A bank looks at the company’s debt-to-equity ratio to assess the risk,” Lemay says. “Banks will generally lend about three or four times what the company has in terms of equity, a major component of which is retained earnings.”
Using the example above, the company has $400,000 in retained earnings, so it can expect to get an increase in borrowing capacity of $1.2 or $1.6 million to speed up its growth.
“Owners could not take out $500,000 in dividends from the company and then turn around and go to a bank and ask for $1 million,” Lemay says. “If you need a loan for a project, you have to leave money in the business in order to reduce the risk for the bank. As an entrepreneur, you can’t have your cake and eat it too!”
As an expert in finance and business management, I can attest to the critical role that retained earnings play in a company's financial health and strategic planning. Retained earnings are indeed the accumulated profits left after a company covers its direct and indirect costs, income taxes, and pays dividends to shareholders. This residual equity represents a crucial source of capital that can be reinvested in the business for activities such as purchasing new equipment, conducting research and development, or implementing marketing strategies.
The article correctly emphasizes the significance of retained earnings when it comes to financial decision-making, particularly in the context of obtaining loans from banks. François-Xavier Lemay, the Manager at the Business Development Bank of Canada (BDC), provides valuable insights into how banks evaluate a company's debt-to-equity ratio to assess risk. Retained earnings, being a substantial component of equity, influence a company's borrowing capacity. Banks typically consider a company's retained earnings when determining the amount they are willing to lend.
Let's break down the concepts discussed in the article:
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Retained Earnings Calculation:
- Sales ($10M) - Variable costs ($4M) - Fixed costs ($5.4M) - Taxes ($100,000) = Net profit ($500,000) - Dividends ($100,000) = Retained earnings ($400,000)
This formula illustrates the step-by-step calculation of retained earnings using a cosmetics company with $10 million in sales as an example. It deducts various costs, taxes, and dividends from the total sales to arrive at the retained earnings.
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Location of Retained Earnings in Financial Statements:
- Retained earnings appear in the shareholders’ equity section of the balance sheet.
The article correctly points out that retained earnings are part of the equity section on the balance sheet, showcasing their significance in understanding a company's overall financial picture.
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Relationship Between Net Profit, Dividends, and Retained Earnings:
- Net profit ($500,000) - Dividends ($100,000) = Retained earnings ($400,000)
This formula emphasizes the relationship between net profit, dividends, and retained earnings. Retained earnings are derived by subtracting dividends from the net profit.
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Analysis of Retained Earnings:
- Banks assess the company’s debt-to-equity ratio, with retained earnings being a major component.
Retained earnings play a crucial role in bank assessments, affecting the debt-to-equity ratio. This ratio is a key factor in determining the risk associated with lending to a company.
The provided information offers a comprehensive understanding of the role, calculation, and impact of retained earnings in a company's financial management, providing a solid foundation for making informed business decisions.
