Lesson 12 - Beginner accounting course

12. The Statement of Retained Earnings: Linking Income and Equity

The Statement of Retained Earnings is a financial report that outlines the changes in a company's retained earnings over a specific period, typically a quarter or a year. Retained earnings refer to the portion of net income that is kept within the company, rather than being distributed to shareholders as dividends. This statement provides a detailed link between the company's net income (or loss) reported on the income statement and its equity, showing how profits are used to either reinvest in the business or returned to shareholders.

What Are Retained Earnings?

Retained earnings are part of a company's equity that accumulates over time from profits that have been reinvested into the business instead of being paid out as dividends. They reflect the company's ability to generate profits and retain them for future growth. This accumulated amount is reported on the balance sheet under shareholder equity.

In essence, the retained earnings balance is a running total of the profits a company has earned and decided to keep (not distribute), which are then used for reinvestment, debt repayment, or saving for future operational needs. For example, if a company has net income of $1 million in a year but decides to pay out $400,000 as dividends, the remaining $600,000 is added to the retained earnings.

Structure of the Statement of Retained Earnings

The statement of retained earnings shows the beginning retained earnings, adds net income (or subtracts net loss), subtracts dividends paid, and then ends with the current retained earnings. Below is the general format of how the statement is structured:

1. Beginning Retained Earnings: This is the retained earnings balance at the start of the reporting period, which is taken from the previous period’s statement.

2. Add: Net Income (or Subtract: Net Loss): The net income or loss from the income statement is included here. If the company made a profit, the net income increases the retained earnings; if there was a loss, it reduces the retained earnings.

3. Less: Dividends Paid: Any dividends paid to shareholders during the period are deducted from the retained earnings. This amount represents the profits that were distributed to shareholders instead of being kept within the company.

4. Ending Retained Earnings: This is the final retained earnings balance at the end of the reporting period. It represents the cumulative retained earnings up to that point in time, which is then reported under shareholders' equity in the balance sheet.

Example of a Retained Earnings Statement:

Assume a company has the following financial data:

• Beginning retained earnings: $2,000,000

• Net income for the year: $500,000

• Dividends paid: $100,000

The statement would look like this:

In this example, the company's retained earnings at the beginning of the period were $2 million. After adding the net income of $500,000 and subtracting the $100,000 dividends paid, the ending retained earnings amount to $2.4 million.

Why Is the Statement of Retained Earnings Important?

The statement of retained earnings serves several important purposes for both internal and external stakeholders:

1. Reflects the Use of Profits

The retained earnings statement shows how the company has used its profits. By retaining earnings, a company can reinvest in its operations, expand its business, pay down debt, or prepare for future financial needs. The statement gives stakeholders insight into whether the company is reinvesting in growth or returning profits to shareholders.

2. Ties Income to Equity

The statement directly connects the company’s income statement (which shows how much money the company made or lost) to its balance sheet (which reflects the company’s equity). Retained earnings are a key component of equity, and the statement helps track how income is either retained or distributed.

3. Indicator of Financial Health

The statement of retained earnings can provide clues about a company’s financial stability and management’s approach to profitability. A growing retained earnings balance indicates that a company is generating consistent profits and reinvesting in its business. However, a declining or negative retained earnings balance could be a red flag, suggesting that the company has been losing money or distributing more dividends than it can afford.

4. Evaluates Dividend Policy

By showing the amount of dividends paid, the statement of retained earnings reflects the company’s approach to rewarding shareholders. Companies that are consistently paying high dividends may not be reinvesting enough in their operations, which could hinder long-term growth. On the other hand, companies with a conservative dividend policy may be reinvesting earnings to fund expansion, innovation, or reduce debt.

5. Essential for Investors and Creditors

Investors use the retained earnings statement to assess how well the company is performing and whether it is in a position to grow and provide future returns. A healthy retained earnings balance can signal potential for future dividends, capital gains, or reinvestment in new projects. Creditors also use this statement to evaluate the company’s financial resilience and its ability to meet debt obligations.

Understanding Retained Earnings and Their Impact on Equity

The amount of retained earnings a company has directly affects its equity, as it is included in the shareholders’ equity section of the balance sheet. As retained earnings accumulate over time, they increase the company’s equity, which is beneficial in terms of financial leverage and stability. This also means that the company can use these retained earnings as a source of funding for future projects, acquisitions, or business operations without needing to take on additional debt or issue more stock.

For instance, a company with large retained earnings may choose to invest in new technologies, buy back stock to boost shareholder value, or pay off outstanding debt, which would improve its financial position.

However, it is also important to note that retained earnings can be reduced if the company incurs a net loss, or if it chooses to distribute a significant portion of its profits to shareholders through dividends. The impact of dividends on retained earnings is crucial, as paying out too much in dividends without having sufficient retained earnings could place the company at financial risk.

Conclusion

The Statement of Retained Earnings is a key financial report that provides valuable information about how a company manages its profits. By showing how much profit is kept within the company and how much is distributed to shareholders, it bridges the income statement and the balance sheet, offering a clear picture of the company’s financial health and decisions. The statement not only highlights the company's earnings but also reflects its strategies in terms of reinvestment, dividend payments, and overall growth. Understanding the statement of retained earnings is essential for investors, creditors, and anyone seeking to analyze the financial sustainability and future potential of a business.