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When it comes to managing your small business accounts, you may have come across retained earnings - but do you know exactly what they are and how they impact your business?
If not, there’s no need to panic.
We’ve put together a helpful guide, taking you through the important nuances of retained earnings and what they mean for your small business.
Let’s get started.
Retained earnings: what are they?
Sometimes referred to as trading profits or surplus earnings, retained earnings are the profit that a business makes once all costs such as salary and shareholder dividends have been accounted for.
Retained earnings are considered a type of business equity, as they indicate a portion of profits that show what the business is worth.
They are shown as cumulative amounts. This means that the balance is carried over from one accounting period to another, with the current period’s net income and losses added or deducted accordingly.
One thing to note with retained earnings is that they aren’t the same as your business cash flow. Your business bank balance will naturally fluctuate with incoming and outgoing payments, whereas retained earnings are solely affected by net income and losses during the current financial period.
Why do retained earnings matter?
In order for a small business to grow, it requires continual investment in personnel, equipment and more. This is where retained earnings can help.
Retained earnings provide that essential capital that can be used to reinvest back into the business to exploit growth opportunities or to pay off outstanding debts.
With the option to self-finance your business through retained earnings, small businesses can avoid the need to go through lengthy and potentially risky loan applications, as the cash is readily available.
Equally, retained earnings can be used to cumulatively save up for new capital expenditures like vehicles or equipment which will allow your business to expand.
Where to find retained earnings?
Many small businesses, including sole traders, may consider retained earnings part of their working capital.
However, it’s best practice to record retained earnings on your balance sheets in their own right, as this can give you greater insight into the overall worth of the business. This is particularly important if you have shareholders or are looking for investors, as retained earnings can serve as a good high-level indicator of a business’s overall financial health.
In terms of where to find retained earnings, typically, they appear with other types of owner equity, liabilities (such as reserves for paying off debts) and shareholder dividends, on the right-hand side of the balance sheet.
While the figure can be the same in some instances, retained earnings aren’t what you record on your income statement. This is net income.
What’s the difference between net income and retained earnings?
For small business owners, it can be challenging to define the difference between net income and retained earnings.
As mentioned above, they sometimes appear as the same amount, but they’re calculated differently.
Net income is calculated from the total amount of revenue a business makes once taxes and expenses have been deducted. It directly contributes to retained earnings, but retained earnings are also affected by dividend payment deductions and net losses.
When it comes to taxation, retained earnings aren’t subject to tax, as they’ve already been applied to the net income. So, in short, retained earnings are the company profits after taxation, dividends and costs are all paid out.
How to calculate retained earnings
When it comes to calculating your business’s retained earnings, you may feel overwhelmed by the range of different figures before you.
However, if you have your net income, losses, dividend figures and your beginning retained earnings figure, they can be worked out using the relatively simple formula below:
Beginning retained earnings + net income / loss – dividends = retained earnings
As retained earnings are cumulative, you may need to calculate your beginning retained earnings for the previous period in order to work out the current period’s retained earnings.
To do this, you can use the following formula:
Retained earnings + dividends – net income / loss = beginning retained earnings
Figures are typically calculated on a monthly, quarterly and annual basis, depending on the preference of your shareholders or potential investors.
If you experience an increase in retained earnings, you may want to show this as a percentage figure on your balance sheet.
To do this, you’ll need to do a simple calculation of the following:
Retained earnings / beginning retained earnings of the same period x 100
For example, for Q2, if your business’s retained earnings were £10,000 and the beginning retained earnings for Q2 were £5,000, your calculation would look like this:
£10,000 / £5,000 = 2
2 x 100 = 200% increase in retained earnings for Q2
This calculation can be automated with a formula if you balance your books using spreadsheets or using online accounting software - you may find they can calculate retained earnings and the increase for you, saving you valuable time.
In the early days of your small business, you may not need to record your retained earnings. However, as your business grows and profits increase, it’s worth having a solid understanding of what they are and how they can impact your company in the future.
Certainly, if you’re looking to expand your business or take on investors, calculating your retained earnings can help you to demonstrate its monetary worth and financial health.
Of course, if you have any more questions about retained earnings or you’d prefer to leave the calculations to the professionals, we’re always happy to help. Get in touch with Harlands today to discuss your needs in more depth.