How to Calculate Retained Earnings
In business, there are many ways of checking whether you are on the path of growth or not. The most common way is to find out whether you are making profits or losses.
Profits are a sure sign of a healthy business, whereas losses indicate the opposite.
But there is more than profits and losses. There are retained earnings.
Retained earnings are the amount of money left after making all the necessary company payments. More specifically, after paying dividends. Dividends tend to be the last payment made by a company. Whatever money remains after this, that is what is referred to as retained earnings.
In the balance sheet, retained earnings are reported as shareholder equity. This is because this money actually belongs to shareholders.
At the end of the company’s financial period, it will be decided whether to pay out a dividend or keep the money. If there will be a dividend payment, then the balance is retained earnings.
If no dividend payment is done, the full amount in the hands of the management is the retained earnings.
Retained Earnings vs Revenue
It is important to differentiate between certain words which can cause some confusion.
Whereas retained earnings remain after dividends have been paid, the money cannot be taken to be the same as revenue.
Revenue is the total income received by your business in the course of the financial period.
If you sell products or services, then your revenue is your total sales before deducting expenses. Revenue is your gross sales.
Retained Earnings vs Net Income
Still, there is another term worth briefly discussing in regards to confusion with retained earnings.
Your gross sales (revenue) are the income before expenses have been deducted. But subtracting your expenses from your revenue still does not give you retained earnings.
Yes, retained earnings come after all payments but remember the keyword here is dividend payment. Dividend is the payment which is made after all other payments. It is however not an expense. Keep in mind that dividend is not paid to a creditor, but the shareholder.
Net income is the money you have left after subtracting all your operational expenses from your revenue. This is the calculation that determines whether you realized a profit or a loss.
It is after realizing a profit, that you can have money for dividends. Otherwise, you really have nothing to present to your shareholders.
And if you have no money for dividends, automatically, you have no extra money to keep as retained earnings.
HOW TO CALCULATE RETAINED EARNINGS
As with many other financial terms, there is a way of getting your retained earnings.
This is a formula which compares your previous financial period’s retained earnings with the current one.
Here is the formula:
Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Pretty straightforward, right?
Beginning Period RE is the retained earnings of the previous financial period. You will have reached this figure by deducting the dividend payout from the Net Income from the last period.
Something else in the formula worth noting is “Stock Dividend.”
Did you know that dividends can also be paid in the from of stock? You may decide that your business will not pay out dividends via cash.
This can be a good plan if you want to keep some liquid assets available for the cash transactions you anticipate.
This will increase the shareholders’ stake in the company.
Retained Earnings Example
Here is an example of the retained earnings of company ABC.
Last year, they had a net income of $120,000. After paying a total of $45,000 in dividends, they remained with $75,000. This amount is their retained earnings of the last financial year. At the same time, it is their current year’s beginning period RE.
In the course of their business this year, they made a profit of $15,000. Because of the reduced profits, they paid shareholders a lower dividend compared to the previous year. The dividends totaled $7,000 from $2 per share for their 3,500 shareholders.
To find their current year’s retained earnings, this is the calculation:
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
RE = 75,000 + 15,000 – 7,000 = 83,000
Thus company ABC’s retained earnings for this year are $83,000.
POSSIBLE USES OF RETAINED EARNINGS
Retained earnings have many uses and they are a real treasure to your business. Being a surplus in the money you have, the number of options available for you are endless.
In most cases, since all the normal expenses have been taken care of, this amount goes into growing the business.
Here are some of the ways you can use the money.
Research and Development
Research is an integral part of any business.
Just as it’s part of the business launching process, so is it when you are already up and running.
In fact, it is more important now because you have to find out the best way to grow your business.
For research and development, you may need to hire a team to find out how to produce better products.
Or cheaper ways to produce your goods.
Alternatively, you can outsource the work and await receiving the final report after the agreed time.
Research and development is an investment which often doesn’t pay off in the immediate short-term.
It may take you two years to realize the benefits of the research you are doing. In other cases, it may take longer and benefit your business indirectly.
An example of this is a company in the technology industry. Lots of research may not help them launch the next-generation product immediately.
However, reporting their research results will give customers and investors confidence in the company.
This will in turn increase their stock prices as it is believed the company is headed in the right direction.
Customers will also prefer buying from the company believing that the research findings mean the company has better technology.
Business expansion is a natural desire for any business owner. As you are meeting the needs you set out to meet, you cannot avoid the need for growth.
All the same, growth is expensive. You have to look for new markets, do more campaigns, create more awareness of your company, buy new machines, etc.
To make this happen, you need money. In case you open a new branch of your business, you will need computers, stationery etc. And all these are acquired using money.
Therefore, having some “extra” money available will prove very helpful.
A major advantage is that you will not have to take an expensive bank loan. Bank loans have high interest rates and if you can avoid them, the better.
Here are a few tips for business growth. All these will come with some initial expense. With your retained earnings, you can easily hire the staff to work on the strategy you pick.
1. Research your competition – you have some competition to beat so as to become number one in your industry. This is the right time to do your homework. Although you may have done this earlier as part of your market research, there are new discoveries to be made.
Good competitor research requires a lot of effort and that means money. You need someone experienced to do it and such a person will have to be paid.
Alternatively, you can use some of your staff, maybe in the marketing department to do the job.
Depending on your industry, this research may take different shapes.
For example, in the retail industry, they may need to go shopping in your competitor’s shop and return the goods. This helps them know their returns policy for comparison purposes.
They may also make wholesale purchases so as to see your competition’s warehousing and logistics operations. Whichever way you choose to go, there will be money being spent.
2. Invest in a customer relationship management system – these have become common and if you don’t have one in place, it is a good time to get it. Instead of trying to manage all your customer data in books or a spreadsheet, a CRM will do a better job.
These offer lots of benefits to businesses. You will able to have all your sales records in one place managed by customer.
You can see the orders placed and the time taken to fulfill them as well as all interactions with the customers.
Having everything under one roof helps you with decision making and cost cutting.
3. Launch a customer loyalty program – different from a customer management system, this one is purely for encouraging customers to become loyal. You want them to come to you more and more.
To the customer, this is a great way of shopping and earning points. The points can be redeemed later for discounts. You can also treat your customers to special gifts on their birthdays. This is possible if you collect their date of birth during registration.
For you however, this is an opportunity to gain insight into your customers’ shopping behavior. With the records of what they buy, how many pieces, how often they buy etc, you have lots of data to make use of.
With this information, you can know which products to stock and which ones to reduce. You can do targeted marketing using related products so as to increase your revenue.
4. Expand into new territories – unless you are already operating in all the cities and towns of the world, you have much ground to cover. New territories can be exciting or disappointing, depending on how you go about them.
The unchanging fact however is that you will need money to conquer them.
Getting into new territory is not easy. There are the various laws to be familiar with. New market research to conduct. Possible language barrier to overcome. Trusted people to find and new customers to be made loyal.
And you are yet to secure land, build offices or rent a warehouse, buy machinery and start producing. Still there are marketing campaigns to run, samples to give away and the list goes on and on.
What do all these activities require?
They all require money. It becomes very easy when you have “extra cash” in the form of retained earnings.
5. Increase your online presence – there cannot be any meaningful growth without an increase in your online presence. Today, the online community must be engaged with your brand if at all you are to have a place in their minds.
Of course this doesn’t mean you stop advertising on the mainstream media if you are doing it. The mainstream media is still a powerful platform but a more cost-effective one is social media.
Do not confuse cost-effective with cheap, or (almost) free. There is a cost involved. If you have a website, chances are that you need to have it improved. If it is purely informational, then it has to change to enable e-commerce. Alternatively, develop a new one.
On top of that, you must have a blog. The blog’s design has to be attractive and the content great. All these things translate into hiring expert web designers, writers and copywriters, social influencers etc. And they cost money.
You will be glad if you have some to start you off.
Pay Off Outstanding Loans
Rarely will there be a business operating without some kind of debt. In fact, big businesses almost always have some very big debts. This does not mean that they are not financially secure.
Debt is commonly used to facilitate investments. Big debt could therefore reflect big investments.
But if you have a big investment and a small debt, won’t that be better?
When you have retained earnings of a significant amount, you can decide to pay off some of your outstanding debts.
Especially bank loans as those are the ones which attract the highest interest payments.
This way, you are able to operate with minimum external pressure.
Although the bank may charge you for paying off your loan early, doing the math right may prove it worthwhile.
In case you are bound by some clauses to stick to your repayment schedule, then you can always clear with your creditors.
Either way, you will get into the new financial year with less debt.
This translates to having more money being freed for other purposes.
Invest in Acquisitions
One of the wisest moves you can make in business is to acquire another business. This becomes an additional income-generating venture for your business.
Look to big companies like Google and Facebook to see the wisdom in doing this. Watch this short video for some great tips on mergers and acquisitions.
Before practicing this wisdom, do a thorough research on the company of interest. Seek professional help in analyzing the profitability of the company.
Are its products selling well? If not, why? Do you have the resources to make that happen? How will your current business benefit from this acquisition? Is this a competitor you are neutralizing? Will this business help your current one compete better in the industry?
Remember that there will be employees to deal with. Are they in support of the acquisition? Are they going to stay or leave? If they stay, will you have their loyalty?
There are a lot considerations to check when thinking about this move. Take your time and be sure to make the right choice.
Also be ready to develop and improve your acquisition so that it is able to provide more returns.
Invest in Producing New Products
Retained earnings can also be used to launch new products into the market. Since this takes some time and work, having the monetary resources required makes it easy to get started.
In case you have already done the research and are satisfied with your findings, then it’s time to get to work.
Buy whatever machines are needed and train whoever needs training. When it comes to purchasing machinery, you must have expert opinion. Involve the relevant staff and engage the services of experts whom you can trust.
The amount of retained earnings will obviously determine how far you can go with your spending. Involving various people in the process of making the move will help you save more money.
This is because you will most likely have within the team, someone who knows the most reliable supplier. Someone else may know the features to check for when buying the machine.
For new products, the employees who will work on the new product should also be involved in the process. There is the marketing team which will source for new customers.
When all your staff are a part of the process, they will give it full support.
Another way of using your retained earnings is to purchase the shares held by shareholders. This is not a very common decision but can still be made.
With this decision, you will have to suggest to the shareholders the amount of money you are willing to pay per share.
Note that this is different from paying dividends.
In paying dividends, you are essentially rewarding your shareholders for their loyalty. You are also thanking them for giving you their money to work with.
But in share repurchase, you are buying back the shares of your company from your shareholders. Therefore, after the exercise, you will have fewer shareholders while having increased your percentage shareholding.
This has the effect of reducing you future dividend payouts since you won’t have many people to pay dividend to.
At the same time, it can be a great time for the shareholders who hold onto their shares.
Normally, when the number of shareholders is small, the amount of dividend paid is bigger.
Those who won’t sell their shares may then benefit more come the end of the next financial year.
Retained earnings are a good way to quickly determine the general health of a business.
This money can be reinvested into the company to facilitate growth.
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