Retained Earnings Explained

Published by Alex on

Whenever a business takes in money, the amount garnered usually gets divided for different allocations. A part of it goes into company expenses, employee salary, equipment updates, inventory, etc. Likewise, a portion of the money goes to the people who invested in the business, the shareholders, in the form of dividends.

Retained Earnings (RE) is what gets left of the net income once investors have been paid their dividends. It is an important indicator of an organization’s standing. It represents the amount that the company keeps to itself, reserve funding that can be reinvested back to the business. Reserved earnings can be negative (losses) or positive (profit), depending on the business’s financial state and performance.

Calculating the retained earnings of a specified interval is fairly easy. Simply follow the formula below:

RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends

This is computed at the end of an accounting period. Succeeding cycles will have the most recent term’s retained earnings as its beginning balance. And as stated above, the resulting number from this calculation may not always be positive and could show negative retained earnings, signifying a loss for the company.

What Impacts Retained Earnings?

Obviously, it is in the best interest of any business to avoid going into the negative spectrum of earnings. While being in full control of the many variables that could affect profit is virtually impossible, there are a few things a company can do to mitigate losses. Part of that is knowing why a company’s retained earnings are negative and what factors impact retained earnings.

There are three types of transactions that can affect a business’s retained earnings. These transactions will cause fluctuations in the company’s financial accounts. It is vital to have all of these events documented in financial statements to make sure that all projections and reports are accurate. The factors to consider here are the following:

  • Dividend Payments

When people invest their own money into a business, they expect a return on this investment. This usually comes in the form of dividends. Stockholders typically receive their dividend payments in regular intervals, at previously discussed dates.

Dividends are not part of the company’s income statement records. It is logged into a separate account, usually for the sole purpose of reporting dividend payments. Because of this, whatever amount is set aside for the investors, it is deducted from the company’s retained earnings. The problem lies in when dividends payments are higher than the income, consequently leading to a negative RE.

Some investors opt out of cashing in on their dividends. Instead, they choose to reinvest the money for business operations.

  • Net Income

Of course, business income is the most evident variable that affects retained earnings. If a business does well in a term, earnings are directly affected, and vice versa. When retained earnings are not depleted by the end of a cycle, it becomes the starting balance for the following period. Businesses heavily rely on their clients to keep their net income in the positives.

  • Net Losses

Overhead payments are one of the leading causes of net loss. Expenses like rent, inventory, equipment, payroll can stack up and equal to more than the net income can supplement. Any events that cause the company to lose money can be labeled as a net loss. Repaying loans, as well as refunded and damaged goods, are also cause of net loss.

How Negative Retained Earnings Impact Business

Negative earnings are a big problem for any business. Apart from the given loss of profit, a company faces many more obstacles, especially with consecutive negative retained earnings balance sheets. This leads to more than one issue, a few of which are:

  1. Decreased shareholder equity. Less earning equals less money for everyone on the table. Not only does it affect those currently within the company, but also potential investors who could bring in exactly what you need to survive.
  2. Potential bankruptcy. A consistent bad performance will almost always lead to inevitable bankruptcy. While it is relatively easy to get over a small deficit of retained earnings, a pile-up of this level of performance points to bigger future problems.
  3. Presents the business as questionable. People don’t like losing money, so investors will ask why the company has been raking in negative retained earnings. They want to track down the source of the problem and whether the company is still worth investing in.

How to Fix Negative Retained Earnings

After deep evaluation, when retained earnings seem impossible to come back from, it is time to cut back on other things. To find out how to fix negative retained earnings, business owners/operators must ask themselves a few questions to answer why are the retained earnings negative:

  1. Is your dividend policy sustainable?

Considering the factors that impact earnings, we can look at the relationship between negative retained earnings and dividends. The dividend doled out to stockholders is possibly bigger than what the company is currently capable of giving. Cutting back on dividends may help take the burden off a little.

Reducing dividend payments is a big deal; make sure you run it through the shareholders, as people do not like being blindsided by this type of change. Alternatively, modifying the schedule for receiving payment is also a viable option.

  1. Are your services seasonal?

Some products and services have their peak seasons. It would be reasonable to expect that summer goods will not sell well during the winter season. Make sure to factor this in when checking your balance, and refrain from panicking because this is normal. A way to tread water during slow seasons is by saving a heftier account balance from good sales terms.

  1. Is the business still profitable?

Despite a business’s initial favorable performance, the company might not have been able to keep up with expenses over time. Are the effort and resources poured into the business still worthwhile? If not, it may be time to reconsider things.

In case the business shows some potential to recover, changing gears could help give it a boost. A new marketing campaign, product launch, or simply stocking up on what’s hottest on the market might help. In an extreme case, a complete rebranding might be called for. A reinvigorated company with fresh ideas is attractive to future investors who are able to spare the funding to help save the business.

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