How to calculate retained earnings for better financial forecasting

While no single metric can predict the future with absolute certainty, understanding your company's retained earnings is a powerful piece of the puzzle for gaining financial clarity. These accumulated profits, when calculated accurately, provide valuable insights into your company's past performance and its capacity for future investment and growth.

In this guide, we'll walk you through the calculation of this crucial metric. Understanding your retained earnings will give you a clearer financial perspective, ultimately empowering you to make better-informed decisions that guide your business towards greater profitability.

What are retained earnings?

Retained earnings (RE) are a company's cumulative net profit that has been kept back within the business and not paid out as dividends to shareholders. 

In simpler terms, retained earnings represent the total profits that the company has "held onto" since its inception, after accounting for any payouts to its owners. This accumulated profit is a vital source of internal funding, allowing your business to invest in growth, manage debt, and weather unexpected challenges without always relying on external finance.

You can find the total amount of these retained earnings clearly stated within the Shareholders' Equity section of your company's balance sheet at the close of each accounting period.

Revenue vs. profit vs. retained earnings

To gain true financial clarity, it's essential to understand the difference between retained earnings, revenue, and profit, and how these fundamental terms are interconnected.

Revenue represents the total income a company generates from its core operations; the money earned from selling its goods or services before any expenses are deducted. 

After a specific period, a company calculates its profit (or net income). This is the earnings left over after deducting all business expenses from the total revenue. Profit represents the financial gain generated during that particular period.

Retained earnings, on the other hand, are the accumulation of all the past profits that the company has earned since its inception, less any dividends paid out. Essentially, retained earnings are the portion of past profits the company has "held onto." 

Therefore, revenue is the starting point, leading to profit after expenses, and the undistributed portion of that profit builds up the retained earnings over time.

The retained earnings formula: Cracking the code

The good news is that calculating retained earnings isn't overly complicated. It boils down to a straightforward formula:

RE = Beginning period RE + Net income/loss – Cash dividends – Stock dividends

Let's break down each component:

• Beginning period retained earnings: This represents the total accumulated profits that the company has retained up to the start of the current accounting period. You can find this figure as the ending retained earnings reported on the balance sheet from the previous accounting period. 
• Net income (or net loss): This is your company's profit after all revenues and expenses (including taxes) for the period have been deducted; if expenses exceed revenue, this will be a net loss, which will decrease your retained earnings.  
• Cash dividends: These are direct cash payments made to shareholders from the company's profits. They directly reduce the retained earnings.  
• Stock dividends: These are dividends paid out in the form of additional shares of the company's stock, rather than cash.

Each of these components ultimately impacts the balance of the retained earnings account over time.

How to calculate retained earnings: Step-by-step guide

Now that we've explored the formula, let's walk through the actual process of calculating your business's retained earnings. By following these steps, you'll be able to accurately track this financial metric for your business:

1. Identify your beginning retained earnings balance

To begin, locate the retained earnings balance on your balance sheet at the very start of the period you're analysing. The balance sheet, which provides a snapshot of your company's assets, liabilities, and equity at a specific point in time, will contain this figure within the shareholders' equity section. 

If this is the first time you're calculating retained earnings for your business, or for its initial operating period, this starting figure will be £0. For established businesses, the ending retained earnings from your previous calculation serves as your beginning retained earnings for the current period.

2. Determine your net income (or net loss)

Next, review your income statement (or profit and loss statement) for the period you're examining. This statement details your company's financial performance over a specific period, showing your revenues and expenses. Find the net income (or net loss) figure, which is often labelled as "profit after tax". 

If your revenue exceeds your total expenses, this will result in a positive net income, increasing your retained earnings. Conversely, if your expenses are higher than your revenue, you'll have a negative number (net loss), decreasing your retained earnings.

3. Account for paid dividends

It's important to keep track of all dividends your company paid to shareholders during the period. This includes cash dividends, which are the total amount of cash paid directly to shareholders, and stock dividends, which represent the value of any additional shares of stock distributed to shareholders.

Both of these types of dividend payments reduce the amount of profit retained within the business, so ensure you have accurate records of all distributions.

4. Apply the retained earnings formula

Finally, it's time to put all the gathered information together using the formula:

Ending retained earnings = Beginning retained earnings + Net income or loss - Cash dividends - Stock dividends

Perform this straightforward calculation to arrive at your ending retained earnings for the period you've analysed. This ending figure will then become your beginning retained earnings for the subsequent accounting period's calculations.

Illustrative example:

To see this formula in action, let's consider a hypothetical small business called "The Coffee Corner." Imagine that at the beginning of the year, The Coffee Corner had £10,000 in retained earnings. Throughout the year, they generated a net income of £30,000. During the same period, they paid out £3,000 in cash dividends to their shareholders and also distributed £2,000 worth of stock dividends.

Now, let's apply the formula:

• Ending retained earnings = £10,000 + £30,000 - £3,000 - £2,000 
• Ending retained earnings = £35,000

Therefore, at the end of the year, The Coffee Corner's retained earnings would be £35,000. This ending balance will then become their beginning retained earnings for the following year's calculations.

Why retained earnings matter for financial forecasting

While retained earnings are a reflection of your business's past profitability and dividend decisions, they are far from being just a historical footnote. This accumulated profit serves as a vital foundation and indicator of its past capacity for growth and financial resilience. 

Here's how interpreting retained earnings can directly inform key business decisions and strengthen your financial forecasting:

Investment opportunities

Your accumulated retained earnings often represent a readily available pool of internal funds. When considering investments in expansion, new equipment, or research and development, a healthy retained earnings balance can reduce the need for external borrowing, saving on interest costs and maintaining greater financial independence. By analysing your projected retained earnings, you can assess the feasibility and timing of these crucial investments within your financial forecasts.

Debt management

A strong retained earnings position can significantly impact your company's ability to manage its debt. Lenders often look at a company's equity when assessing creditworthiness. Higher retained earnings can indicate a lower risk profile and a greater capacity to repay loans. When forecasting, projecting healthy retained earnings can support plans for debt reduction or taking on new debt.

Dividend policy

For businesses that distribute profits to shareholders, retained earnings play a crucial role in determining sustainable dividend payouts. A consistent track record of healthy retained earnings growth suggests the business has the capacity to continue or even increase shareholder dividends in the future. Forecasting retained earnings helps in setting realistic and sustainable dividend policies that balance shareholder returns with the company's reinvestment needs.

Overall financial stability

Retained earnings act as a financial buffer for your business. They represent profits that have been kept within the company and can be used to absorb unexpected losses, navigate economic downturns, or seize unforeseen opportunities. Accurate forecasting of retained earnings helps you project the growth of this safety net and assess your company's long-term financial stability and resilience.

Common pitfalls to avoid: Steering clear of errors

While the retained earnings formula is straightforward, some common mistakes can skew your calculations and undermine your financial forecasting. These include:

• Incorrectly reporting net income: Errors in revenue, expenses, or tax accounting directly impact your RE.
• Overlooking or miscalculating dividends: Forgetting cash or stock dividends leads to an inflated RE.
• Using outdated beginning RE: Starting with the wrong prior period balance throws off all future calculations.
• Ignoring prior period adjustments: Failing to correct past accounting errors misstates your current RE. Reviewing a retained earnings statement can highlight these adjustments.

Practical advice for ensuring accuracy

To ensure your retained earnings calculations provide a reliable foundation for your financial forecasting, consider implementing the following practices:

Regular reconciliation

Compare your financial records regularly, including your income statement, balance sheet, and dividend records, to identify and correct any discrepancies promptly. This regular check-up acts as an early warning system for potential errors.

Leveraging accounting software

Utilise reliable accounting software to automate many of the calculations involved in tracking your financials and retained earnings. This significantly reduces the risk of manual errors. Ensure your software is set up correctly and that all transactions are accurately input and categorised.

Maintaining thorough documentation

Keep detailed and organised records of all financial transactions. This includes revenues, expenses, and all dividend distributions (both cash and stock). Comprehensive documentation provides a clear audit trail and simplifies the process of verifying your retained earnings figures.

Seeking professional guidance

Don't hesitate to consult with a qualified accountant or financial advisor if you have any doubts or uncertainties regarding your financial reporting or the calculation of retained earnings. Their expertise can provide valuable insights and help you avoid potentially costly mistakes, ensuring the accuracy and reliability of your financial data.

Leveraging retained earnings with Futrli: A powerful partnership

Futrli is a cash flow forecasting and reporting platform that automates the process of building financial projections. By connecting to your accounting software, Futrli simplifies access to your financial data, including the figures needed to understand retained earnings.

With Futrli, you can create forecasts that automatically project key elements impacting your retained earnings, such as net income and dividends. This automation provides a clear view of your likely future retained earnings balance, helping you make more informed decisions for your business's financial planning.

Ultimately, Futrli streamlines the forecasting process, saving you time and providing valuable insights into your potential retained earnings trajectory.

Steer your business with confidence

Understanding your retained earnings provides a historical perspective on your business's profitability and reinvestment capacity. Accurately calculating this accumulated profit is the foundation for informed financial planning. By avoiding calculation errors, you ensure a reliable starting point for your projections.