What Is a Statement of Retained Earnings?

What Is a Statement of Retained Earnings?

Let me explain what a statement of retained earnings is. It's a financial statement that shows the changes in retained earnings for a company over a specific period. This statement reconciles the beginning and ending retained earnings, pulling in details like net income from other financial statements. You can use it to see how corporate profits are being handled.

You might also hear it called a statement of owner's equity, an equity statement, or a statement of shareholders' equity. It's prepared following generally accepted accounting principles (GAAP).

Here are the key takeaways: This statement details changes in retained earnings volume over a period. Retained earnings are profits held in reserve for future projects instead of dividends. You can look at it to understand a company's plans for deploying profits toward growth.

What Is Included in the Statement of Retained Earnings?

This statement can stand alone or be part of a balance sheet or income statement. It includes the firm's retained earnings, net income, and dividends distributed to stockholders. You'll see the net income noted, which is set aside for obligations beyond dividends or to cover losses. Each statement covers a specific time period as indicated.

What Is the Purpose of Retained Earnings?

These funds, also known as retained profit or accumulated earnings, are often used to pay down debt or reinvest in the company for growth. When a company makes surplus income, long-term shareholders might expect dividends as a reward, and short-term traders often prefer them for quick gains. Dividends come from profits, reducing retained earnings.

The surplus allocated to retained earnings can be used in several ways: to expand operations like boosting production or hiring sales reps; to launch new products, such as a refrigerator maker adding air conditioners; for mergers, acquisitions, or partnerships; for share buybacks; or to repay loans.

Benefits of a Statement of Retained Earnings

Releasing this statement improves market and investor confidence in the organization. It serves as a marker for analyzing the firm's health. Retained earnings aren't just surplus funds; they're redirected for reinvestment. In capital-intensive industries or growth periods, retained earnings are typically higher due to asset development needs. For instance, a tech company will have higher retained earnings than a T-shirt manufacturer because of the focus on product advancement to stay competitive.

Why Is the Retention Ratio Important?

From the statement, you can derive the retention ratio, which is the proportion of earnings kept as retained earnings. It's the percentage of net income retained for growth rather than paid as dividends, opposite to the payout ratio. This ratio shows how much a company keeps to reinvest. If a company pays out all earnings or doesn't reinvest well, growth suffers, leading to more debt or new equity. It helps determine the reinvestment rate, but hoarding too much might mean ineffective cash use. New companies often retain all earnings for growth, while established ones balance dividends and reinvestment.

How Do You Calculate Retained Earnings?

To calculate retained earnings, start with the previous period's retained earnings, add net income or subtract net loss, then subtract dividends and cash dividends.

What Is the Difference Between the Income Statement and Retained Earnings?

An income statement covers revenues, expenses, gains, and losses. In contrast, the retained earnings statement shows profits held for future investments.

Are Dividends Paid Out of Retained Earnings?

Dividends are paid from net profits, not directly from retained earnings. However, when calculating retained earnings, you subtract dividends along with adjusting for net income or loss.

The Bottom Line

Retained earnings are crucial for a company's health, as they fund growth through new products, buybacks, or acquisitions. For you as an investor, this statement reveals how profits are used and reinvested, with higher retention ratios often pointing to solid financial health.