Negative Retained Earnings
What Does Negative Retained Earnings Mean?
If a business has negative retained earnings, this is likely to have a significant impact, particularly on investment and shareholder dividends. But, in order to understand and calculate negative retained earnings, a company must first get to grips with its retained earnings. Getting to grips with the issue and understanding what does negative retained earnings mean is absolutely key for any business. The presence of negative retained earnings can sometimes be an early indicator of bankruptcy and, at the least, may point to a prolonged period of loss-making on the part of the company.
Retained earnings refer to the total net income of a business after it has paid dividends to its shareholders. If a business is flourishing, shareholders may be paid dividends as a reward for their financial support. After these payments have been made, earnings can be reinvested back into the company. The size of the dividend paid to its shareholders will be determined by the business and may depend on the company’s aims for the future. Should a company be focused on growing, the size of dividends paid to shareholders may be relatively small.
This poses the question: what is negative retained earnings? This occurs when the total net earnings, minus the dividend payments, resulting in a negative balance. This can be an indication that the company is struggling, but it can also occur in otherwise profitable companies if dividend payments are high. For example, a company may experience relatively robust earnings for a quarter, but this can be wiped out by the huge scale of dividend payments to shareholders.
How Do You Calculate Retained Earnings?
Retained earnings are influenced by a number of things that either increase or decrease a company’s income and profitability. First and possibly foremost, this might be sales revenue. This has a direct impact on a company’s retained earnings balance. If the company is experiencing a period of increased sales, this may lead to an increase in retained earnings. Conversely, a sustained period in which sales are poor is likely to see an increase in the chances of negative retained earnings.
Likewise, operating expenses such as payroll costs, insurance, marketing, or rent directly impact. The more these factors increase, the less chance a company has to be profitable. If a company can keep these costs low, it has a better chance of becoming profitable. Similarly, if the cost of the goods sold – the cost of the material to the company – increases, this will impact profitability. A company should also be aware that other factors such as the depreciation of an asset will also be a factor in the long run. Can retained earnings be negative for a business? If it is unable to keep costs from increasing and dividend payments to shareholders remain robust, then the
answer is yes.
Example of Negative Retained Earnings
Let’s look at an example of a retained earnings negative scenario for a hypothetical business.
Gorilla’s Choice is a retailer that sells bananas. The business has 1,000 outstanding shares and a retained earnings balance of $20,000. In one year, the business earns $20,000 selling bananas and issues dividends of $20 per share. The income would raise the retained earnings balance to $40,000, and the payment of shareholders’ dividends would reduce it by $20,000, leaving $20,000 in the retained earnings account.
Let’s say that the next year, the company loses $25,000 selling bananas. That would lead to a negative balance of $5,000. This negative balance is referred to as negative retained earnings.
What to Do When Your Company Has Negative Retained Earnings
Asking the question of why is retained earnings negative for a business is not always straightforward. Identifying and addressing the problem could be an intricate and sustained piece of work requiring a substantial amount of intelligence and effort.
A business should carry out a careful analysis as to how they have found themselves less profitable. The impact in earnings could be as a result of increased costs, changes in the marketplace, fluctuating trends, or increased pressure from competitors. In order to drag the earnings balance back into the positive, the company may wish to look at cutting costs or look to obtain additional funding. This can often be a long, laborious process, and a company looking at how to fix negative retained earnings may be a less attractive prospect for investors.
Wrap Up: Negative Retained Earnings
Negative retained earnings can be an indicator that a business is looking weak and an early sign of potential bankruptcy. Certainly, it will point to a period, whether brief or sustained, in which earnings are relatively weak or cash flow is a problem. It does not necessarily spell doom for a business, though. Negative retained earnings can be influenced by a myriad of factors and may be understood and budgeted for by a business, particularly if that business is new. It may be a temporary state of affairs for a company that is investing to cover a period of expansion, requiring costs to increase in the short term. However, in the long term, businesses will, by and large, look to avoid seeing their earnings balance tip into the negative. Remember, retained earnings can be influenced by a range of factors, including costs, fluctuations in the market, developing trends, and competitor pressure. Careful analysis will need to be undertaken by the business to determine how it has arrived at a state where retained earnings are now negative.
Retained earnings, negative or otherwise, will also play a crucial role in the payment of shareholders’ dividends. Getting to grips with the scale of negative retained earnings will influence how much you may wish to pay to shareholders or whether you want to earmark that money for investment in the growth of the business. Identifying retained earnings and getting to grips with the issue of negative retained earnings is crucial for a large-scale business and could be the difference between failure and survival and the company’s eventual success.