Retained earnings represent the portion of a company’s net income that is kept by the business instead of being distributed to shareholders as dividends. Computing retained earnings from a balance sheet involves a simple calculation using information found within the financial statements. Understanding how to compute retained earnings is essential for assessing a company’s profitability and financial health. In this article, we will not only address the question of how to compute retained earnings from a balance sheet but also provide answers to 12 related frequently asked questions.
How to Compute Retained Earnings from a Balance Sheet
To compute retained earnings from a balance sheet, follow these steps:
1. Locate the previous period’s retained earnings: Find the retained earnings figure from the balance sheet of the previous accounting period. This information is typically available in the equity section of the balance sheet.
2. Add net income: Identify the net income for the current accounting period, which can be obtained from the income statement. Net income is the company’s total revenue minus all expenses and taxes.
3. Subtract dividends: Subtract any dividends paid to shareholders during the current accounting period. Dividends are usually reported in the statement of changes in equity or the notes to the financial statements.
4. Calculate retained earnings: Add the net income to the previous period’s retained earnings and then subtract any dividends paid. The resulting figure represents the current period’s retained earnings.
For example, suppose a company’s balance sheet shows retained earnings of $100,000 for the previous period. In the current period, the net income is $50,000, and the company paid $10,000 in dividends. To compute the retained earnings for the current period, add the net income of $50,000 to the previous period’s retained earnings of $100,000, and then subtract the dividends of $10,000. The calculation would look like this:
$100,000 (previous retained earnings) + $50,000 (net income) – $10,000 (dividends) = $140,000 (current retained earnings)
Therefore, the retained earnings for the current period amount to $140,000.
Frequently Asked Questions (FAQs)
1. What are retained earnings?
Retained earnings represent the cumulative net income of a company that has been retained rather than distributed to shareholders as dividends.
2. Are retained earnings the same as profit?
No, retained earnings are not the same as profit. Profit refers to the amount of income remaining after deducting expenses and taxes, while retained earnings are the accumulated total of profits retained by the company over time.
3. Can retained earnings be negative?
Yes, retained earnings can be negative if a company’s accumulated losses exceed its retained earnings or if prior dividend payments have exceeded the company’s net profit.
4. Where can I find retained earnings on a balance sheet?
Retained earnings are typically listed in the equity section of a balance sheet, under shareholders’ equity or stockholders’ equity.
5. How do retained earnings affect a company?
Retained earnings reflect the profitability and financial stability of a company. They can be used for reinvestment in the business, debt reduction, and future dividend distributions.
6. Can retained earnings be withdrawn?
Retained earnings are not cash or assets that can be directly withdrawn from a company. They represent an accounting measure of a company’s accumulated profits.
7. Can retained earnings be negative forever?
No, negative retained earnings are generally not sustainable in the long term. If a company continues to generate negative retained earnings, it may face financial difficulties or insolvency.
8. Why do retained earnings increase?
Retained earnings increase when a company generates net income and does not distribute all of it as dividends. This can occur through increased revenue, decreased expenses, or a combination of both.
9. Should retained earnings be positive?
Ideally, retained earnings should be positive as it indicates that a company has accumulated net profits over time. However, negative retained earnings might result from temporary losses or aggressive dividend payments.
10. Are retained earnings reinvested?
Retained earnings can be reinvested in the company for various purposes, such as research and development, acquisitions, expansion, debt reduction, or increasing cash reserves.
11. Do retained earnings carry over to the next year?
Yes, retained earnings from one accounting period carry over to the next year. The balance of retained earnings is included in the subsequent period’s balance sheet.
12. How are retained earnings different from reserves?
Retained earnings refer to profits that have not been distributed as dividends, whereas reserves generally represent specific funds set aside for future contingencies, such as tax liabilities, legal claims, or asset replacement.