As a business owner, meeting or exceeding your sales forecasts is one of the most fulfilling moments in your entrepreneurial journey. It validates your hard work and time invested in all areas of your business. Moreover, robust sales revenue, either monthly, quarterly or annually, can boost your profits and open up new growth opportunities. Any net earnings or profits not distributed to you or your business's co-owners or shareholders (if applicable) are referred to as retained earnings.
It is essential to understand the ins and outs of retained earnings and how to calculate them. This Huddle Business Capital blog article offers valuable insights that can enhance your knowledge of this accounting concept.
What are retained earnings?
In the opening section of this blog article, we briefly explained retained earnings, but let's discuss them in greater detail. Retained earnings, like the name implies, are net earnings or profits retained after your business's operational costs (e.g., employee payroll, marketing fees, inventory) have been accounted for and following the distribution of any bonuses or dividends to you, your co-owners, and shareholders (if applicable).
Retained earnings indicate your business's financial health and stability. By retaining earnings, you can build up your company's working capital and use it to cover operational costs, expand your product or service lines, or enhance your marketing efforts, to name a few.
How to calculate retained earnings.
If you track your business's finances regularly and keep accurate accounting books, you can easily calculate your retained earnings. Your accounting methods may differ, but retained earnings typically appear on a business balance sheet in the equity section.
The formula is straightforward: Add your beginning-period retained earnings to your net income (or loss) and subtract any cash dividends and stock dividends.
Beginning Period Retained Earnings + Net Income/Loss – Cash Dividends – Stock Dividends = Retained Earnings
Let us use a fitness center as an example. The center's retained earnings for the prior quarter totaled $120,000; its net income was $60,000, and its two owners took $10,000 ($5,000 each) in cash dividends. To calculate the fitness center's retained earnings, the owners would need to do the following calculation:
$120,000 + $60,000 - $10,000 = $170,000
In this scenario, the fitness center has $170,000 in retained earnings that can be allocated to support various business initiatives and operational needs.
What are negative retained earnings?
Business losses are recorded in the retained earnings column on a business balance sheet. If the total loss surpasses the profit recorded as beginning-period retained earnings, this indicates negative retained earnings. Negative retained earnings can be a sign of financial distress or excess debt. They may raise concerns for investors and creditors about the business's ability to generate future profits.
The business owner (s) must address negative retained earnings reported over several quarters or years. Long-term financial losses can hinder business growth and sometimes result in bankruptcy.
Revenue vs. profit vs. retained earnings.
Revenue, profit, and retained earnings are interconnected. Revenue represents the income (sales) coming into your business from its regular operations over a specific period before any expenses are accounted for. Profit is the amount of money remaining after subtracting your business's expenses from your sales revenue. The portion of the profit you retain in your business and do not distribute to yourself, your co-owners, or shareholders (if applicable) is retained earnings.
Factors that impact retained earnings.
The income generated by your business is influenced by a variety of financial factors, including sales revenue, cost of goods sold (COGS), and operational expenses. Your business's retained earnings will be directly related to its net income. For instance, an increase in sales revenue combined with a decrease in operational expenses can lead to a higher allocation of funds to retained earnings.
On the other hand, a decline in sales revenue, along with an increase in operational expenses, may result in a lower allocation of funds to retained earnings.
What to do with surplus business income.
If your business has surplus business income, congratulations! This shows that your company is performing well financially. Now, you just need to decide what to do with the surplus. Every business owner's situation is unique, so there is no one-size-fits-all solution for managing surplus income.
That said, there are a few options to explore. These include reinvesting a portion of the surplus into your business, creating an emergency fund, paying down debt, or giving yourself and your employees a bonus. Just remember to take a conservative approach and retain as much working capital as possible.
Disclaimer.
This Huddle Business Capital blog article is purely educational and contains general information and opinions; it is not intended to provide advice or recommendations of any kind.
