Give tips to succeed in business or brilliant business ideas.

Retained Earnings Formula

Retained Earnings Formula

One of the crucial parameters in the evaluation of a company's future prospects are its retained earnings. Companies retaining a part of their profits may not share any dividends with shareholders and usually invest the surplus in developing their business further or paying off debts. The formula for calculation of this important financial parameter, is presented in the following lines.
Omkar Phatak
Warren Buffett's Secret
In March, 2014, the total retained earnings of Berkshire Hathaway were US$ 148.45 billion. Warren Buffett, the company's CEO and Chairman doesn't believe in paying dividends, as the complete reinvestment of profits into other lucrative businesses, powers the relentless compounding machine, that Berkshire Hathaway is. This strategy has helped the book value of the company grow at a rate of 19.7% for 48 years, outclassing even the S&P 500, which grew at a rate of 9.4%, over the same period.
If you look closely at a company's quarterly financial report, there will be several details mentioned in there. One of the most important numbers that you as a shareholder should note is the retained earnings value of the company. It is an important parameter for gauging the performance of the business in any quarter.

What are Retained Earnings?

How do companies grow and develop their capital base to initiate new developments that give them the edge to compete with other industries in a sector? It is only through reinvestment of their own profits in a business. The reinvested profit tucked away for future or immediate investment in the company's business endeavors or debt clearance, that is not shared with stockholders as dividend, is known as the retained earnings of a company.

In technical language, it is the part of the net income that is reinvested by a public listed company in its business after paying out dividends to its shareholders. It is an important parameter of consideration in stock research.

It is up to the management how it uses the earnings for the benefit of the business. The funds may be diverted towards repayment of an outstanding debt or they may be used to further developmental or expansion plans.

The value of retained earnings will usually be listed under shareholder's equity details in the company balance sheet. Instead of consuming the earnings, if they are invested smartly, a company prospers. It can create new assets and develop new projects which can help it cope with competition in a ruthless market.

The Formula

Here is the formula required for calculation of this crucial accounting parameter.

Retained Earnings (RE) = (Beginning Retained Earnings + Net Income - Dividends Paid)

Thus, you need to know three parameters, which includes the beginning or previous retained earnings from earlier quarters, the company's net income, after adjusting for losses and taxes, and dividends paid. If there is a net loss, it will be subtracted from the beginning RE. The following calculator provides you with a direct value of the retained earnings, provided you enter the three required parameters.

Retained Earnings Calculator
Enter Beginning RE
Enter Net Income
Enter Paid Dividends

This surplus cash can be used for research and development or to clear out any of the outstanding debts that a company might be facing. It may also be used for marketing and buying of new machinery.

If the company suffers a loss in a quarter, exceeding past retained earnings, the net value of current retained earnings will be negative. This obviously doesn't spell good news for investors and therefore, a negative RE may indicate a company with financial problems. It is also possible that the negative RE is a result of dividend value paid out, which is higher than current retained earnings, which can happen rarely in some cases. Consistently rising RE is indicative of healthy growth of a company and points towards its success in gaining a competitive advantage in the market.

Managing earnings is one of the prime financial management goals of any company. Great CEOs are marked by their ability to make good use of earnings for the company's expansion in more areas. These funds provide a company with an opportunity to adapt with changing conditions and enter into previously unexplored territory, where it can increase its sales.

Using the Formula

Now that you know the formula, all that you have to do is substitute the requisite values of certain parameters to compute RE. Let me illustrate it with an example.

A company has previous retained earnings of US$ 1,000,000. In the past quarter, it has recorded a net income of US$ 1,500,000 after taxes, out of which US$ 300,000 must be paid in dividends. What will be the retained earnings of the company?

Using the above formula:

Retained Earnings = (US$ 1,000,000 + US$ 1,500,000 - US$300,000 ) = US$ 2,200,000

Using the formula presented above, one can account for the surplus profit made by the company, which is available for reinvestment. As explained before, retained earnings are what drive the growth of a company. Companies that have reached the top have managers who know how to invest these earnings wisely.