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Financial Statement Analysis

Retained Earnings Equation – A Practical Guide + Real Examples

5 mins

The retained earnings equation shows how much profit your business keeps after paying dividends. It’s simple but powerful, helping you track how profits are reinvested to grow or stabilize your company.

 

In this blog, we’ll explain retained earnings, how the equation works, and share real examples of how businesses use it to make smarter financial decisions. 

 

If you want to understand how financial statements play a role, check out our guide on financial statement analysis.

What Is the Retained Earnings Equation?

The retained earnings equation tells you how much profit your business has saved over time. Instead of paying all your profits out as dividends, you can keep a portion to reinvest in the company.

 

Here’s how the equation works:

Retained earnings equation: Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings

Think of retained earnings as a running total of how much profit your business keeps. 

Example: Let’s say a manufacturing company uses retained earnings to upgrade its equipment. This reinvestment leads to higher efficiency and better margins, showing how retained earnings help long-term growth.

Retained earnings also appear in the equity section of your balance sheet. They’re an important measure of how well a business manages its profits over time.

How Does This Work - An Example

Let’s see the formula in action.

Say a company starts the year with $800,000 in retained earnings. Over the year, it earns $300,000 in net income and pays $100,000 in dividends to shareholders.

 

Here’s the calculation:

  • Beginning Retained Earnings: $800,000
  • Net Income: $300,000
  • Dividends: $100,000
 

Retained Earnings = $800,000 + $300,000 – $100,000 = $1,000,000

 

At the end of the year, the company has $1,000,000 in retained earnings it can use to invest in equipment, expand operations, or pay down debt.

Retained earnings also show how much profit has been reinvested in the company over time. 

 

For a deeper understanding of how retained earnings connect to financial statements like income and cash flow, check out our guide on the 3-statement financial model.

How Businesses Use the Retained Earnings Equation

The retained earnings equation helps businesses decide how to save and reinvest their profits.

 

A retail business might use retained earnings to open new stores without taking out loans. Another company could use them to pay off debt, lowering interest payments and improving cash flow. Retained earnings also help fund research and development, leading to new products or better services.

 

Here’s a complete list:

how businesses use retained earnings: expanding earnings, paying off debt, building a safety net, share buybacks, paying special dividends, employee development, sustainability initiatives

The best way to use retained earnings depends on the company’s goals. Fast-growing businesses might reinvest in expansion, while more established companies could focus on paying down debt or rewarding shareholders.

 

For more on how companies reinvest profits, check out our guide on retained cash flow.

Where Retained Earnings Fit in Financial Statements

Retained earnings show up in the equity section of the balance sheet. Retained earnings also connect to other key financial statements:

 

Income statement: Net income from the income statement feeds into retained earnings. If a business doesn’t generate profit, retained earnings won’t grow.

 

Cash flow statement: Retained earnings don’t always reflect available cash. For example, cash reinvested in new equipment will reduce cash flow but not retained earnings.

Example: A company’s balance sheet might look like this:

  • Shareholders’ equity
    • Common stock: $500,000
    • Retained earnings: $1,000,000
    • Total equity: $1,500,000

Retained earnings are a key indicator of how much profit a company has reinvested over time to strengthen its financial position.

 

To learn more about balance sheets and how retained earnings fit into them, check out our guide on comparative balance sheets.

Pros and Cons of Retained Earnings and What They Mean for Your Business

The retained earnings equation is a great way to track how much profit a business keeps and reinvests. But like any financial tool, it has its strengths and weaknesses.

Pros

  • Funds growth directly: Retained earnings make it possible to invest in new projects, expand operations, or upgrade equipment without taking on debt or giving up ownership.
  • Reduces dependency on external funding: Companies with healthy retained earnings don’t have to rely as much on loans or outside investors.
  • Increases flexibility: A strong balance of retained earnings gives businesses more room to handle unexpected costs or invest in opportunities as they come up.
  • Enables long-term planning: Retained earnings can fund projects that take time to generate results, like entering new markets or major infrastructure upgrades.
  • Builds trust with lenders and shareholders: Companies that consistently reinvest profits often gain better borrowing terms and long-term support from investors.

Cons

  • Not the same as cash: Retained earnings aren’t liquid funds. The money might already be tied up in assets or other investments.
  • Can reduce shareholder returns: Keeping too much in retained earnings means less money distributed as dividends, which could upset some investors.
  • Risk of poor reinvestment decisions: If retained earnings are used for projects that don’t deliver results, it can waste resources and hurt growth.
  • May create tax inefficiencies: Depending on how profits are retained or distributed, companies might face higher tax burdens.
  • Can lead to hoarding in mature companies: Older businesses with fewer growth opportunities may hold onto retained earnings without using them effectively, leading to inefficiency.
 

Retained earnings work best when businesses carefully balance reinvestment with rewarding shareholders. They should also be analyzed alongside other metrics, like cash flow, ROI, and debt, to ensure smart financial decisions.

For more on why the balance sheet doesn’t always tell the full story, check out our guide on primary limitations of the balance sheet.

How Apple Uses the Retained Earnings Equation

Apple is one of the most profitable companies in the world, with strong retained earnings. This shows how much of its profits Apple has saved and reinvested to stay the market leader.

A photo of the Apple Park
Source: Unsplash

Here’s what Apple does with its retained earnings:

 

  • Invests in new products: Apple spends billions each year on research to create products like the Apple Watch and improve devices like the iPhone.
  • Buys other businesses: Apple has used retained earnings to buy companies like Beats Electronics, helping it grow its product lineup and strengthen its brand.
  • Repurchases shares: Apple runs large share buyback programs, which reward its shareholders and increase the value of its remaining stock.
 

Apple’s strategy shows how retained earnings can drive growth and create value when used effectively.

 

For more on how retained earnings connect to other financial statements, check out our guide on the 3-statement financial model.

Why the Retained Earnings Equation Matters

The retained earnings equation shows how much profit a business keeps to grow, reduce debt, or plan for the future. It’s a simple way to track how well profits are being managed and reinvested.

 

Companies like Apple show how retained earnings can drive innovation, help growth, and increase shareholder value. Businesses can use retained earnings to invest in new projects, improve operations, or strengthen their financial position.

 

FP&A tools like Farseer can help make you understand your finances better and make smarter decisions about how to use retained earnings. 

 

Start making profits work harder for your business today.

FROM THE BLOG

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