Retained earnings represent the cumulative net profits a company has retained in the business.
For any given period, retained earnings equal the period’s net income minus any dividends paid to shareholders in the period. Cumulatively, retained earnings equal the beginning balance of retained earnings plus the period’s net income minus any dividends paid over the period.
Retained earnings are a component of shareholders’ equity and are shown on the balance sheet.
Retained earnings do not represent the amount of cash that has been retained in the business. This is due to several factors. First, net income is calculated on an accrual basis, meaning that recognition of revenue and expenses may not coincide with cash payments or collections. Second, the calculation of net income includes non-cash items, such as depreciation, amortization, and asset impairments. Third, certain payments, such as payments made to reduce outstanding debt or payments made to acquire assets, are accounted for in the income statement. To analyze the change in the company’s cash balance, an investor or analyst reading the company’s financials must consult the statement of cash flows.
As an example of retained earnings, consider the following: For the year 2023, a company has after-tax earnings of $25 million. The company pays $20 million in dividends. The balance sheet as of December 31, 2022, shows total retained earnings of $30 million. What are the retained earnings for 2023 and the total retained earnings as of the end of the year?
For the year, the retained earnings are $25 million in net income minus $20 million in dividends, or $5 million. The total of retained earnings on the balance sheet as of year-end 2023 equals the $30 million beginning balance plus the $5 million in retained earnings for the year, or $35 million.