How to Calculate Retained Earnings: Complete Accounting Guide

Retained earnings represent the cumulative net income a company keeps after paying dividends to shareholders. Understanding this metric is essential for business owners, investors, and financial analysts assessing company health and growth potential.

Retained Earnings Formula:

Ending Retained Earnings = Beginning Retained Earnings + Net Income - Dividends Paid

This calculation appears on the statement of retained earnings and connects directly to the balance sheet under shareholders' equity.

What Are Retained Earnings?

Retained earnings are the portion of a company's profits that management decides to reinvest in the business rather than distribute to shareholders as dividends. These accumulated earnings fund:

• Business expansion and growth initiatives
• Research and development projects
• Debt reduction and financial stability
• Equipment purchases and capital improvements
• Working capital and operational reserves

Think of retained earnings as the company's savings account—profits earned over time that remain in the business.

The Retained Earnings Formula Explained

Ending RE = Beginning RE + Net Income - Dividends

| Component | Definition | Where to Find It | |-----------|-----------|------------------| | Beginning RE | Retained earnings from last period's balance sheet | Previous period's balance sheet | | Net Income | Total profit after all expenses and taxes | Income statement (bottom line) | | Dividends | Cash or stock paid to shareholders | Cash flow statement or notes | | Ending RE | Current period retained earnings | Current balance sheet |

The formula captures three key actions: starting with what you had, adding what you earned, and subtracting what you paid out.

Step-by-Step Calculation

Example 1: Small Business (Basic Calculation)

Green Valley Coffee Shop - Year 2024

Step 1: Find beginning retained earnings Balance sheet shows: $45,000 (from Dec 31, 2023)

Step 2: Identify net income for the period Income statement shows: $30,000 net profit for 2024

Step 3: Determine dividends paid Owner withdrew: $8,000 in distributions

Step 4: Apply the formula Ending RE = $45,000 + $30,000 - $8,000 Ending RE = $67,000

This $67,000 appears on the Dec 31, 2024 balance sheet under equity.

Example 2: Public Company (Complex Scenario)

TechCorp Industries - Q1 2024

Beginning retained earnings (Jan 1, 2024): $2,450,000 Net income (Q1 2024): $580,000 Cash dividends declared: $120,000 Stock dividends: $50,000

Calculation: Ending RE = $2,450,000 + $580,000 - ($120,000 + $50,000) Ending RE = $2,450,000 + $580,000 - $170,000 Ending RE = $2,860,000

Note: Both cash and stock dividends reduce retained earnings.

Example 3: Negative Net Income (Operating Loss)

Startup Solutions LLC - Year 2024

Beginning retained earnings: $120,000 Net loss for year: -$45,000 (negative income) Dividends paid: $0 (no distributions during loss year)

Calculation: Ending RE = $120,000 + (-$45,000) - $0 Ending RE = $120,000 - $45,000 Ending RE = $75,000

Retained earnings decreased because the company lost money, but remain positive overall.

Statement of Retained Earnings

This financial statement shows the calculation explicitly:

ABC Company - Statement of Retained Earnings For Year Ended December 31, 2024

| Line Item | Amount | |-----------|--------| | Beginning retained earnings (Jan 1, 2024) | $500,000 | | Add: Net income | $150,000 | | Less: Cash dividends | ($40,000) | | Less: Stock dividends | ($10,000) | | Ending retained earnings (Dec 31, 2024) | $600,000 |

This statement bridges the income statement and balance sheet, explaining how profit flows into equity.

Negative Retained Earnings (Accumulated Deficit)

When retained earnings turn negative, accountants call this an "accumulated deficit." This occurs when:

Total losses exceed total profits over the company's lifetime

Example: Beginning RE: -$30,000 (already in deficit) Net loss: -$20,000 Dividends: $0

Ending RE = -$30,000 + (-$20,000) - $0 = -$50,000 accumulated deficit

What causes accumulated deficits?

• Startup companies burning cash before profitability
• Mature companies experiencing sustained losses
• Heavy dividend payments exceeding cumulative profits
• Large one-time write-offs or restructuring charges

Investor implications: Negative retained earnings signal financial stress but aren't automatically disastrous. Many successful companies (Amazon, Tesla) showed deficits early while reinvesting aggressively.

Retained Earnings vs Revenue vs Profit

This distinction confuses many business owners:

Revenue (Sales):

• Total money received from customers
• Top line of income statement
• Example: $1,000,000 in sales

Net Income (Profit):

• Revenue minus ALL expenses and taxes
• Bottom line of income statement
• Example: $150,000 profit after costs

Retained Earnings:

• Accumulated profits NOT paid as dividends
• Cumulative over company's entire life
• Balance sheet equity account
• Example: $600,000 total reinvested since founding

Key point: Revenue and profit are periodic (monthly, quarterly, annual). Retained earnings are cumulative since inception.

How Retained Earnings Affect the Balance Sheet

Retained earnings appear under Shareholders' Equity section:

XYZ Corp Balance Sheet (Partial) December 31, 2024

Shareholders' Equity:

• Common stock: $100,000
• Additional paid-in capital: $200,000
• Retained earnings: $600,000
• Treasury stock: ($50,000)
• Total equity: $850,000

When retained earnings increase, total equity rises. When they decrease, equity falls.

The accounting equation remains balanced: Assets = Liabilities + Equity

If net income increases retained earnings by $100,000, either assets increase or liabilities decrease by $100,000.

Tax Implications of Retained Earnings

Corporate Level

Retained earnings are already taxed. Companies pay corporate income tax on net income before calculating retained earnings. Keeping profits in the business doesn't create additional corporate tax.

Shareholder Level

C Corporations: Shareholders pay no personal tax on retained earnings until dividends are paid or stock is sold. This creates "double taxation"—corporate tax on earnings, then dividend tax when distributed.

S Corporations and LLCs: Owners pay personal income tax on profits immediately, whether distributed or retained. Retained earnings represent after-tax money in pass-through entities.

Tax Strategy Considerations

• Retaining earnings defers shareholder taxes (C corps only)
• Accumulated earnings tax (AET) penalizes excessive retention beyond business needs
• Reasonable business purposes (expansion, debt repayment) justify retention
• IRS may challenge retention exceeding $250,000 ($150,000 for service businesses) without documented purpose

Common Mistakes in Retained Earnings Calculations

1. Confusing Net Income with Cash Flow

Retained earnings increase by net income, not cash received. A profitable company may have negative cash flow due to accounts receivable, inventory purchases, or capital expenditures.

Mistake: Assuming $100,000 in retained earnings means $100,000 in the bank. Reality: Retained earnings represent cumulative profits, not available cash.

2. Forgetting Stock Dividends

Stock dividends reduce retained earnings even though no cash leaves the company. They transfer value from retained earnings to common stock accounts.

Example: 10% stock dividend on 100,000 shares at $20/share = $200,000 reduction in RE

3. Using Gross Profit Instead of Net Income

Only net income (after ALL expenses, interest, taxes) flows to retained earnings.

Wrong: Beginning RE $50,000 + Gross Profit $100,000 - Dividends $10,000 = $140,000 Right: Beginning RE $50,000 + Net Income $60,000 - Dividends $10,000 = $100,000

4. Ignoring Prior Period Adjustments

Error corrections and accounting changes may require restating beginning retained earnings.

5. Missing Appropriated Retained Earnings

Companies may legally restrict retained earnings for specific purposes (debt covenants, legal reserves), reducing amounts available for dividends.

Retained Earnings in Financial Analysis

Return on Retained Earnings (RORE)

Measures how effectively management reinvests profits:

RORE = (Current Year Net Income - Prior Year Net Income) ÷ Prior Year Retained Earnings

Example:

• Prior year net income: $100,000
• Current year net income: $115,000
• Prior year RE: $200,000

RORE = ($115,000 - $100,000) ÷ $200,000 = 7.5%

Interpretation: Each dollar of retained earnings generated 7.5 cents in additional profit.

Retention Ratio

Percentage of net income retained (not paid as dividends):

Retention Ratio = (Net Income - Dividends) ÷ Net Income

Example: Net income $100,000, dividends $30,000 Retention Ratio = ($100,000 - $30,000) ÷ $100,000 = 70%

The company reinvests 70% of profits and pays out 30%.

Dividend Payout Ratio

Inverse of retention ratio:

Payout Ratio = Dividends ÷ Net Income

Example: $30,000 ÷ $100,000 = 30%

Growth companies typically have low payout ratios (high retention). Mature companies show higher payout ratios.

Retained Earnings for Different Business Types

Startups

• Usually negative initially (accumulated deficit)
• Focus on growth over dividends
• Investors evaluate burn rate and path to profitability

Growth Companies

• Positive retained earnings increasing rapidly
• Minimal or zero dividend payments
• Reinvest profits into expansion

Mature Companies

• Large accumulated retained earnings
• Regular dividend payments
• Balance growth investment with shareholder returns

Declining Companies

• Declining retained earnings despite no dividend increases
• May indicate operational problems
• Sometimes liquidate retained earnings through special dividends

Frequently Asked Questions

What is the formula for retained earnings? Ending Retained Earnings = Beginning Retained Earnings + Net Income - Dividends Paid. This formula shows how profits accumulate in the business after paying shareholders.

Can retained earnings be negative? Yes, negative retained earnings are called an accumulated deficit. This happens when cumulative losses exceed cumulative profits over the company's history. Startups often show deficits before reaching profitability.

Where do retained earnings appear on financial statements? Retained earnings appear in the equity section of the balance sheet and are detailed in the statement of retained earnings. They connect the income statement to the balance sheet.

Do retained earnings equal cash? No, retained earnings represent cumulative profits, not cash. A company with $500,000 in retained earnings may have minimal cash if profits were invested in equipment, inventory, or used to pay down debt.

How do dividends affect retained earnings? Both cash and stock dividends reduce retained earnings. Cash dividends decrease both retained earnings and assets (cash). Stock dividends transfer value from retained earnings to common stock without affecting total equity.

What is a good amount of retained earnings? Context matters. Growth companies should show increasing retained earnings. Mature companies balance retention with dividends. Compare retained earnings to total equity (RE ratio) and industry peers for context.

How are retained earnings taxed? Corporate profits are taxed before becoming retained earnings. C corporation shareholders pay no additional tax until receiving dividends. S corporation and LLC owners pay personal tax on profits immediately, whether distributed or retained.

Can you pay dividends with negative retained earnings? Generally no. Most jurisdictions prohibit dividend payments that would create or increase a deficit. Some allow dividends from current year profits despite accumulated deficits. State law and articles of incorporation govern this.

What causes retained earnings to decrease? Retained earnings decrease when: (1) the company experiences a net loss, (2) dividends exceed net income, (3) prior period error corrections reduce historical earnings, or (4) treasury stock purchases in some accounting treatments.

How do retained earnings relate to shareholder equity? Retained earnings are one component of total shareholder equity. Total equity = Common Stock + Additional Paid-In Capital + Retained Earnings - Treasury Stock. Retained earnings typically represent the largest equity component for profitable, established companies.

Pro Tips for Business Owners

Track quarterly: Don't wait for year-end. Monitor retained earnings quarterly to understand cumulative performance and equity position.

Compare retention ratio to peers: Industry norms vary. Tech companies often retain 80-100% of profits. Utilities typically retain 40-60%.

Document retention purposes: For tax planning, maintain written documentation explaining business reasons for retaining earnings (IRS accumulated earnings tax defense).

Consider optimal dividend policy: Balance shareholder returns with growth funding. Consistent dividend policies signal financial stability to investors.

Use retained earnings for financial covenants: Debt agreements often require minimum retained earnings levels. Violating covenants can trigger default.

Understand cash vs. accrual: Retained earnings reflect accrual accounting profits, not cash flow. Maintain separate cash flow projections.

Ready to calculate your company's retained earnings? Use our Profit Margin Calculator and ROI Calculator for deeper financial analysis and business metrics.