Retained Earnings Explained: What It Reveals About Your Business's Lifetime Profitability

Getting ready to apply for a commercial loan, but not sure if your financials will receive an approval from the bank? This post continues our series explaining financial equations and ratios so that you feel more prepared when you talk to the bank about your loan request. Next up: Retained Earnings.

What Is Retained Earnings?

Retained Earnings measures the lifetime financial performance of a company and is found in the Equity section of the Balance Sheet. When a business closes its fiscal year, its Net Income is transferred to Retained Earnings. This resets all revenue and expense accounts to zero for the new year. As the name implies, Retained Earnings is also reduced by money that owners draw out of the company. Similarly, Retained Earnings does not factor in any owner investments — investments are made separate from earned profits and tracked in a different equity account. Here's how you can calculate it:

Why Is Retained Earnings Important?

Retained Earnings is important because it tracks the cumulative profitability of a company, unlike Net Profit recorded on the Profit & Loss Statement. A company with positive retained earnings has been able to record a profit over its lifetime and has been an asset to its owner(s). Companies that operate with negative retained earnings drain cash and owner investments — they cannot stay in business unless they receive more debt or investment to cover losses.

Retained Earnings tracked over time can also show upswings and downturns in a business. A business that has shown record profits the last two years but has negative Retained Earnings has improved its profitability from the past and should continue to do so. On the other hand, a company with positive Retained Earnings that has decreased the last two years without owner draws is showing warning signs that operations need to be improved.

Example of Retained Earnings

ABC Company has Retained Earnings of $500,000 reported on its Balance Sheet and recorded a Net Profit of $50,000 for the year. Owner John Doe also took a $100,000 distribution from the company in addition to his wage. Its current Retained Earnings would be:

Notice how despite earning a positive Net Profit, Retained Earnings decreased in value from the previous year due to the owner taking out more money than the company earned in the financial period. Making a profit doesn't always mean Retained Earnings will increase.

Interested in learning more about Retained Earnings or applying the formula to your own financials? Please feel free to reach out — I would be happy to help!