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How to Calculate and Manage Retained Earnings

Man in a suit holding a smart phone

Man in a suit holding a smart phone

Man in a suit holding a smart phone

Retained earnings are the income that has stayed in your business from the startup phase to the current reporting period. Thriving businesses have a variety of expenses, such as supplies, equipment, maintenance, repairs, research, labor, insurance, advertising, and taxes. Retained earnings are the money remaining after all of these expenditures, minus any dividends paid out to investors. Learning how to manage your retained earnings is an important part of financing and growing your business.

For some businesses, accumulating retained earnings is easier than others. A business requiring frequent replacement of expensive machinery will probably have less retained earnings than a service business that operates with little or no machinery or equipment.

If a business has lost money, it's called retained losses. Retained earnings and losses are cumulative from year to year with losses offsetting earnings.

Calculating Retained Earnings

1. Calculate your net income during the reporting period. Take your total sales for the period and subtract your expenses, operating costs, depreciation of your fixed assets and taxes.

2. Look up the retained earnings from the previous reporting period. If your business is new, this will be “$0.”

3. Add the net income and the retained earnings. Subtract any dividends paid out to shareholders. The remaining sum is your retained earnings.

For example, calculating retained earnings for Nifty Nail Salons looks like this:

Sales for the year

$2,000,000

Less expenses:

 

Total operating costs

$1,000,000

Depreciation

$60,000

Total expenses

$1,060,000

 

Income before taxes

$940,000

 

Less income taxes @30%

$282,000

Net income

$658,000

 

Retained earnings from previous periods

$3,000,000

Plus net income

$658,000

Total retained earnings

$3,658,000

Managing Retained Earnings

Retained earnings are often reinvested in the business, such as when a company expands by buying another business, opening up a new location, developing a new product or vertically integrating. How successful your business expansion strategy depends on how effective you are in making capital allocations from your retained earnings. Retained earnings may also be used to upgrade the business’s equipment, for research and development or to pay down debt.

When using retained earnings, look for opportunities that give your company a competitive advantage and have an attractive ROI. Businesses with a competitive advantage are unique products or services where the advantage lies with the product rather than the people running the business, such as Hershey's Chocolate and Coca-Cola. If you have a small company, your goal could be to build your products or services into an important brand name.

Not all businesses, even widely admired ones, possess a durable competitive advantage. For example, airlines are now a commodity service, where the lowest price wins. Some high tech companies have the disadvantage of constantly reinventing themselves, and, therefore, are subject to becoming irrelevant overnight.

Here are some business characteristics to look for when investing retained earnings:

  • The product or service has had years of experience
  • The business can be expected to make the same product in the future
  • The business spends little money on research and development
  • Their product or service has a long lifespan
  • The business serves a repetitive need (such as razor blades)
  • The business is fairly simple

Another option is to pay out your retained earnings as dividends to investors or shareholders of your company. Investors will look at how you are using retained earnings in your business, and they will want an increased profit and possibly a payoff, either in dividends or an increasing share price. Since paying retained earnings as dividends can limit how much a company can grow, deciding whether or not to pay dividends or invest in the company’s growth can be a difficult balance. Ultimately, what matters most is an increasing share price, since that is a sign that the company is profitable.

For more information on using retained earnings, read Session 6 of MOBI’s Business Expansion Course. If you need help with your business growth strategy, sign up for the MOBI Business Expansion certificate course.

Oct 10, 2017