In the course of business, money comes in and goes out, resulting in profits and losses. As these amounts accumulate, they are tracked in an account called Retained Earnings. As the name implies, these are funds the business holds onto, or retains. Generally, the money is reinvested into the business or held in reserve for a specific purpose, either to pay down debt or obtain new assets. The funds are not used to pay dividends to owners or shareholders. Retained earnings can also be referred to as retained capital or accumulated earnings.
Retained earnings are reported on a financial statement called a Balance Sheet. They are listed in the equity section and continue to change as the business evolves. All profits and losses from the first day of business are posted to this account. Retained earnings are cumulative.
To calculate retained earnings, the first period’s net profit or loss is posted to the account. In the following period, net income can be added to the previous balance, or a net loss can be deducted from it. If dividends are paid out to owners or shareholders, they would be deducted from the net profit or net loss before being moved into the retained earnings account.
Let’s look at a landscaping business: Mark’s Lawns. The first year of business was profitable, but losses resulted in later years. Here’s what would be recorded in the retained earnings account, assuming no dividends were paid.
$25,000 Net profit
Retained earnings: $25,000
($4,500) Net loss
Retained earnings: $20,500
($2,000) Net loss
Retained earnings: $18,500
$3,900 Net profit
Retained earnings: $22,400
Using this example, Mark’s Lawns has accumulated retained earnings of $22,400 in the fourth year.
Since retained earnings accumulate over time, it’s best to analyze a business by comparing retained earnings, when the businesses have been in operation for approximately the same period of time. A company in operation for 20 years may have accumulated a significant amount of retained earnings, which may not reflect the current profitability when compared to a younger company.