Statement of Retained Earnings
Financial statements are crucial to any business. Besides revealing past wins and losses, you need these documents to know your current position and future expectations. One such document is a statement of retained earnings. You can create it as an individual document or combine it with your company’s income statement or balance sheet. So, what is a statement of retained earnings?
Statement of Retained Earnings Definition
Before you define statement of retained earnings, you should first understand how retained earnings work. Retained earnings represent the net profit portion that your business keeps for future use. A retained earnings statement details net profit and income changes after shareholders receive their dividends. Though this statement normally covers one year, you can use it for shorter monthly and quarterly periods.
Not to be mistaken for a statement of owner’s equity. While an SOE applies to sole proprietorships, a retained earnings statement is created by corporations that accommodate shareholders in their business structure.
You might also confuse retained earnings with revenue. Revenue represents the earnings from services and product sales that appear at the top of your income statement. However, retained earnings are the income statement’s profits that appear on the shareholder’s equity segment on a balance sheet.
Additionally, retained earnings differ from reserves. Though the reserve account comes from the retained earnings account, reserves have a predetermined use, for example, paying off a particular debt. Moreover, reserves fall under the balance sheet’s liabilities section, while retained earnings appear under equities.
Another common mix-up occurs between retained earnings and bank balances. Bank balances fluctuate according to the business’s cash flow. Conversely, retained earnings depend on the current net income or loss.
Some uses of retained earnings include:
- Debt repayment: You can use the earnings to pay suppliers, utility bills, and bank loans. Besides building credit scores, timely debt payment reduces interest rates and protects company ownership.
- Share buybacks: Corporations may buy back their stock’s public shares when consolidating their business. Share buybacks increase an investor’s confidence in your company by proving you have extra cash on hand. Furthermore, buybacks boost stock prices by lowering supply. Companies can repurchase their shares and sell them once their prices are high enough to reflect company values. Not forgetting the tax benefits. If you hold shares for extended periods, the business enjoys reduced capital gains rates.
- Expansion: The business can channel the money into upgrading infrastructure, building new plants, and getting more employees to support the development. You can also explore new delivery channels and promote other uses for existing products. By expanding your business, you broaden your products’ reach and improve your shot at funding opportunities. You also get to hire new employees with unique talents.
- Launching new products: Retained profits increase a company’s product offerings. For instance, a fashion line can bring a new clothing design into the market. Companies can also invest in product testing to increase future earnings.
- Meeting unexpected expenses: Retained earnings cushion your business from economic downturns by meeting emergency expenses such as repairs, supplier costs, and rent increases.
- Mergers and acquisitions: Partnerships increase a company’s market dominance in several ways. They increase capital access, reduce competition, and diversify risk for starters. Businesses can also get new talents and tap into their partners’ customer base. An organization can use retained profits to finance mergers and acquisitions. Mergers occur when two companies join forces to build one entity. Conversely, an acquisition represents the takeover of one company by another.
When to Use a Retained Earnings Statement
You can use a statement of retained earnings in different scenarios. Here’s what to consider when analyzing the report:
- Company’s Age. Older companies have higher retained earnings since they have more time to make money. However, new businesses can keep high amounts if they’re growing rapidly.
- Business Cycles. Seasonal companies experience different growth cycles in a year. For instance, snow removal businesses post higher retained earnings in winter than in summer.
- Industry. Certain sectors generate higher retained earnings than others. Take the case of technology. Because businesses want to keep up with industry trends, technological companies retain more profits for regular equipment acquisition.
- Dividend Policies. Companies that pay regular dividends post lower retained earnings. Investors can use dividend policies to evaluate a company’s financial health.
Purpose of Statement of Retained Earnings
A statement of retained earnings aims at calculating retention and payout ratios. Otherwise called plowback ratios, retention ratios are profits held by companies for future projects. Conversely, payout ratios are portions sent to shareholders.
New businesses rarely pay dividends since they need money to grow the company. However, established businesses have enough cash for shareholders and growth projects. The following stakeholders will find a retained earnings statement useful:
- Owners. A statement of retained earnings evaluates changes between different financial periods to track growth. You can even compare your retained earnings to other companies to gauge your position in the industry. The statement also facilitates decision-making. By knowing the available funds, business owners can decide what to allocate to research, development, and facilities expansion.
- Creditors. Your current creditors can gauge your ability to clear debts by looking at the available funds on your retained earnings statement. Potential lenders also need to assess whether your venture is doing well enough to repay its loans.
- Shareholders. A statement of retained earnings guides shareholders on whether to sell, buy or hold stocks. For instance, an investor can project a company’s growth from its high retained earnings, prompting them to buy more shares. Remember, low retention ratios don’t always spell doom. For example, service-based businesses may post low retention ratios because they don’t need heavy product development reinvestment.
How to Prepare a Statement of Retained Earnings
After understanding the statement of retained earnings definition, the next step is preparing the document. You don’t have to be a finance expert to prepare a statement of retained earnings. Here’s how to do a statement of retained earnings on your own:
- Write a Heading. The company name goes on the header’s first line. The second line should read, “Statement of Retained Earnings”, while the third indicates the report’s accounting period.
- Register the Past Year’s Balance. That’s your statement’s first item. You can find this balance on your balance sheet or general ledger. If you have a past report, carry over the beginning balance from the previous period. On the other hand, the starting balance is zero if you’re preparing your first statement of retained earnings.
- Include Net Income. The net income represents your company’s earnings for the current financial period. If you made a net loss, deduct it from your beginning balance.
- Minus Shareholder Dividends. Deduct shareholder bonuses from the net income if your company paid dividends during a particular accounting period. You can include the dividends sent to the business owner and other investors if the company isn’t publicly-traded.
- Total Retained Earnings. You’ll post this amount on the next balance sheet’s retained earnings account. Remember to review the document to avoid calculation errors. You can compare your statement of retained earnings with past reports to ensure accuracy. You could also run your document by a financial advisor. Since formats constantly change, a financial expert ensures your statement meets current standards.
- Additional Information. The statement’s footnotes may contain extra information that affects dividend payment. An example of such information is the stock’s par value, representing its value at issuance.
Example Statements of Retained Earnings
Matt’s Spare Parts
Statement of Retained Earnings
For the year ending December 31, 2021
Beginning retained earnings on January 1, 2021: $150,000
Net income December 31, 2021: =+$20,000
Retained earnings balance December 31: $155,000
The statement of retained earnings may not accompany every financial report, but this document is useful for any business owner intending to expand their business and attract investors. The best part is that the statement of retained earnings is easy to prepare even without financial knowledge.