“Many stock options in the corporate world have worked in exactly that fashion: they have gained in value simply because of management retained earnings, not because it did well with the capital in its hands. ” ― Warren Buffet
This was a strong statement on the importance of retained earnings. Whenever an organization reaps a huge profit in its business, it either pays its employees/shareholders cash flow such as dividends, or reinvests a portion of the profit in business again. So, for retaining earnings in business, there should always be a proof on how the earnings have been utilized in increasing the profitability of a business. The executives of a company create a balance sheet under shareholder equity giving a gist of the retained earnings calculation. Also, this practice enlightens the shareholders about how wisely their money has been invested in the business over the years, promoting the company’s growth.
Warren Buffet once stated – “Unrestricted earnings should be retained only where there is a reasonable prospect – preferably backed by historical evidence, or when appropriate by a thoughtful analysis of the future, that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.” Hence for a booming business, the primary goal is to create USD 1 in the market for every USD 1 of the retained earnings.
How to Calculate Retained Earnings?
Calculating retained earnings is an essential activity in any organization which is keen on growing and increasing its profitabilities. These earnings are the summation of all the profits a company has made since it came into existence. In a balance sheet of a company, this comes under the equities section where it is stated as the cumulative account of all the earnings of a company since its inception sans the dividends.
- For making any calculation regarding investments, profits, and dividends, one must have all the relevant information concerning the financial statements of the company. So, gather the sales, costs, depreciation, interest expense, dividends, and tax rate related information.
- With the information in hand, determine the net income which can be obtained by deducting the costs, depreciation, and interest from the gross sales.
- Calculate the tax rate and deduct the tax rate from the net income.
- Now, subtract the dividends from the net income to get the retained earnings.
Besides, there are a few more points to be kept in mind when doing calculations. We know that the retained earnings are sum of the net profits made by the company and the net income sans the dividends. However, if the earnings reflect a negative amount, it will be termed as deficit in the stockholders’ equity section of the balance sheet. Hence, the balance sheet must have an entry for the modified earnings whenever losses are incurred.
|Gross Sales||USD 800,000|
|Total Costs||USD 200,000|
|Interest expenses||USD 15,000|
Calculating net income
Net Income (NI) = Gross Sales (GS) – (Costs + Depreciation + Interest)
NI = USD 800,000 – (USD 200,000 + USD 35,000 + USD 15,000) = USD 800,000 – USD 250,000 = USD 550,000
Removing tax rate amount from the NI
NI – (NI * Tax rate) = USD 550,000 – (USD 550,000 * 0.24) = USD 418,000
Retained earnings calculation
Retained Earnings (RE) = NI – Dividends
RE = USD 418,000 – USD 100,000 = USD 318,000
After deducting all expenses, taxes, and payment of dividends to shareholders, the retained earnings sum to USD 318,000. This calculation was for the first financial year of the company. For cumulative calculations, the earnings of the previous years are also added to the net income.
RE (t) = RE (t-1) + NI – Dividends (where ‘t’ is the year for which the retained earnings are being calculated.)
Retained earnings calculation is a beneficial aspect for any company when it plans its business growth strategies. Many a time, these earnings are used for accumulating assets, which become the means of income generation for the company. With this extra income, the company has a scope to invest the earnings in research and development, which further assists in the growth of the company. At times, these earnings are also used in clearing debts and liabilities. Hence, calculating earnings is an integral part of every balance sheet maintained by a company. After all, it helps in improving the financial status of an organization and sustaining the good will of its shareholders.