What are retained earnings? (2024)

Retained earnings stand as a testament to a business’s growth and its strategic financial prudence over time. This financial concept, essential for both startups and established enterprises, plays a vital role in shaping a company’s future through reinvestment and debt management strategies.

In the complex world of business finance, the term «retained earnings» often confuses both new business owners and people enthusiastic about finance. Retained earnings play a crucial role in the financial health and expansion potential of businesses, big or small. Whether you’re a startup owner in Pune or managing a family business in Bangalore , understanding retained earnings can significantly impact your financial decisions and business strategy.

What are retained earnings?

At its core, retained earnings refer to the profit that a company has decided not to distribute to its shareholders as dividends. Instead, this profit is kept (or «retained») by the business for reinvestment in its operations, such as paying off debt, purchasing new equipment, or expanding the enterprise. It’s essentially the savings of a business, accumulated over time, to fund future projects or bolster the company’s financial standing.

Retained earnings provide a clear indication of a company’s profitability and the efficacy of its management in reinvesting earnings effectively. For businesses, especially in competitive markets like India, retained earnings can be a vital source of funding for growth without having to increase debt or issue new shares.

Read also: The ultimate guide to liquidity and cash flow

Retained earnings formula

To understand how retained earnings are calculated, let’s break down the formula. The calculation of retained earnings is straightforward:

Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid

Beginning retained earnings are the retained earnings balance from the end of the previous fiscal period.

Net income is the profit the company has earned during the current period, which is added to the beginning retained earnings.

Dividends paid represents the total dividends that have been distributed to shareholders, which is subtracted from the sum of the beginning retained earnings and net income.

The result is the retained earnings at the end of the current period, ready to be reported in the financial statements.

Are retained earnings the same as reserves?

In the intricate world of business finance, terms like «retained earnings» and «reserves» often create confusion. While they may seem similar at first glance, understanding their distinct roles can clarify financial strategies and decision-making processes. Let’s delve into the differences between retained earnings and reserves, shedding light on this common query among business owners and finance enthusiasts.

What sets them apart?

Retained earnings: As mentioned, retained earnings are the portion of net income that a company keeps back from distribution to shareholders. These earnings are reinvested into the business for various purposes – be it for expansion, paying off debt, or other operational requirements. Retained earnings are accumulated over time and reflect the company’s decision to reinvest profits back into the business rather than distribute them. 

Reserves: On the other hand, reserves represent a portion of earnings that a company sets aside to strengthen the financial health of the business. Reserves can be created for a specific purpose or as a general safeguard against future uncertainties. For example, a company may establish a reserve for anticipated future expenses, such as equipment replacement or expansion, or to buffer against unexpected events like economic downturns or emergencies.

The allocation process

The process of allocating funds to reserves typically takes place after retained earnings are calculated. From the retained earnings, companies can decide to allocate a portion into various reserves, earmarking them for specific future uses or general contingency purposes. This allocation is often influenced by regulatory requirements, company policies, or strategic financial planning.

The role in financial statements

While retained earnings are prominently featured in the shareholders’ equity section of the balance sheet, reserves are also listed under this section, sometimes within retained earnings or separately, depending on the purpose of the reserve and accounting practices. The classification and presentation can vary but the important aspect to note is that both retained earnings and reserves are fundamental components of a company’s financial health and strategic planning.

Where does retained earnings go on a balance sheet?

In the framework of a balance sheet within Indian accounting standards, retained earnings occupy an essential position under the shareholders’ equity section. The balance sheet, a crucial financial document, outlines a company’s assets, liabilities, and shareholders’ equity at a given moment, integrating retained earnings as a fundamental element of equity.

The structure, as per Indian accounting norms, is arranged as follows:

1. Assets
2. Liabilities
3. Shareholder’s Equity – This section includes retained earnings, alongside other forms of equity like common stock.

Positioning retained earnings in the shareholders’ equity section emphasizes its importance as part of the wealth belonging to shareholders. Nevertheless, these earnings are not immediately distributable as cash to shareholders but are designated for reinvestment back into the company, signifying a commitment to future growth and stability.

Understanding where retained earnings are located on the balance sheet can provide investors and stakeholders with valuable insights into the company’s operational success and plans for future growth. It reflects a company’s ability to generate profit and its decisions on whether to distribute those profits as dividends or retain them for future endeavours.

Retained earnings for sole traders and partnerships

While the concept of retained earnings is commonly associated with incorporated entities like companies, it’s vital to understand how this concept translates into the financial dynamics of sole traders and partnerships. These business structures, prevalent across various sectors in India , have unique characteristics regarding profit distribution, reinvestment, and equity management. Let’s explore how retained earnings function within sole trader and partnership contexts.

Sole traders: personal profit retention

For sole traders, the business is an extension of the individual owner, and legally, there’s no distinction between the business and the owner. Profits made by the business are considered the personal income of the sole trader. However, similar to retained earnings in companies, sole traders can choose to reinvest a portion of these profits back into the business instead of taking it all as personal income. 

In this context, retained earnings could be funds set aside for future expansion, equipment upgrades, or as a financial cushion for leaner times. Although not labelled formally as «retained earnings» in financial statements, the concept applies as reinvested profits supporting the business’s growth and sustainability. This reinvestment is reflected in the increased value of the business’s assets or decreased liabilities on the balance sheet.

Partnerships: shared profit retention

Partnerships operate on a basis somewhat similar to sole traders, with profits and losses shared between partners according to their agreement. Here, retained earnings represent the portion of profits not withdrawn by the partners and instead reinvested in the partnership. Decisions on retaining earnings versus distributing them among partners typically require consensus, based on the partnership agreement.

Just like in corporations, retained earnings in a partnership are crucial for funding future projects, enhancing the partnership’s ability to grow without relying solely on external financing. These earnings can also serve as a reserve to cushion the business against future financial challenges. The allocation of retained earnings will be detailed in the partnership’s financial records, impacting the equity accounts of each partner proportionately.

Unlocking the power of retained earnings

Retained earnings aren’t just a figure on the financial statements. They symbolise a business’s past decisions and its prospects for future growth. By wisely managing retained earnings, Indian companies can finance their expansion, innovate, and improve their competitive edge without diluting ownership or taking on excessive debt. Whether you’re reviewing your business’s financial health or considering an investment, understanding retained earnings is an invaluable part of financial literacy in the business world.