What are Retained Earnings?
Retained Earnings measures the total accumulated profits kept by the company to date since inception, which were not issued as dividends to shareholders.
The discretionary decision by management to not distribute payments to shareholders can signal the need for capital reinvestment(s) to sustain existing growth or to fund expansion plans on the horizon.
- What is the formula for calculating retained earnings?
- Which factors should be considered when evaluating a company’s retained earnings balance?
- What specific drivers cause the retained earnings balance to increase (or decrease)?
- Is it possible for retained earnings to turn negative?
In This Article
Retained Earnings Formula
The retained earnings of a company refer to the profits generated, and not issued out in the form of dividends, since inception.
On the balance sheet, the retained earnings line item is recorded within the shareholders’ equity section.
The formula used to calculate retained earnings is equal to the prior period retained earnings balance plus net income. And from that figure, the issuance of dividends to equity shareholders is subtracted.
In effect, the equation calculates the cumulative earnings of the company post-adjustments for the distribution of any dividends to shareholders.
The prior period retained earnings balance can be found on the beginning of period balance sheet, whereas the net income is linked from the current period income statement.
Dividend issuances can be obtained from a variety of financial reports such as:
- Statement of Changes in Equity
- Retained Earnings Statement
- Income Statement – Listed in the Section Below Net Income
Retained Earnings Value Drivers
Higher retained earnings mean increased net earnings and fewer distributions to shareholders (and vice versa).
One influential factor on retained earnings is the maturity of the company, as a low-growth company with minimal opportunities for capital allocation is more likely to issue dividends to shareholders.
In other words, cash from operations is sufficient to fund reinvestment needs. However, opportunities to place capital for expansion are limited (or the risk profile does not meet the return hurdle).
With that said, a high-growth company with minimal free cash flow will conversely re-invest toward extending its growth trajectory (e.g. research & development, capital expenditures).
And it’s also likely the company probably could not afford to issue dividends to shareholders in the first place, even if it wanted to compensate shareholders.
Next, another important consideration is the dividend policy of the company. Given the formula stated earlier, the relationship between the two should be rather intuitive – i.e. a company that issues dividends routinely is going to have lower retained earnings, all else being equal.
Even if a company underperforms, the management teams of publicly traded companies tend to be very reluctant to cut dividends out of fear of sending out a negative message to the markets that could cause a significant drop in the current share price.
Furthermore, the cyclicality of the industry can also be a contributing factor. When a company operates in an industry that is very cyclical, the management team reserves more earnings as a risk-averse measure in case of an impending downturn.
Negative Retained Earnings
If a company has consistently incurred substantial losses at the “bottom line,” its retained earnings balance could eventually become negative, which is recorded as an “accumulated deficit” on the books.
But while the first scenario is a cause for concern, a negative retained earnings balance could also result from an aggressive dividend payout – e.g. dividend recapitalization in LBOs.
Caveat for Positive Retained Earnings
As a broad generalization, if the retained earnings balance is gradually accumulating in size, this demonstrates a track record of profitability (and a more optimistic outlook).
However, from a more cynical view, the growth in retained earnings could be interpreted as management struggling to find profitable investments and project opportunities worth pursuing.
Excel Template Download
Now that we’ve defined the meaning of retained earnings and which specific factors increase (or decrease) the profit measure, we’ll go through an example modeling exercise in Excel.
To download the spreadsheet, fill out the form below:
Retained Earnings Calculation Example
For our retained earnings modeling exercise, the following assumptions will be used for our hypothetical company as of the last twelve months (LTM), or Year 0.
Model Assumptions (Year 0)
- Retained Earnings – Beginning of Period: $200m
- Net Income: $50m
- Common Dividends: $10m
Upon combining the three line items, we arrive at the end of period retained earnings balance.
For Year 0, the ending retained earnings balance is $240m.
- Retained Earnings (Year 0) = $200m + $50m – $10m
Note how in our roll-forward schedule, net income has a positive impact on the end of period balance (i.e. cash inflow) while common dividends have a negative effect (i.e. cash outflow)
Retained Earnings Projection
In the next step, we’ll forecast the retained earnings balance for the next five years, with two operating cases to pick from:
- Upside Case: Consistent operating performance with profit margins in-line with historical trends – therefore, the common dividend issuance program remains in place.
- Downside Case: Poor operating performance with declining profitability – management is forced to cut the dividend (and eventually put a complete end to the payouts in later periods)
Upside Case – Forecast Assumptions
- Net Income: Straight-Line (i.e. Held Constant)
- Common Dividends: Straight-Line
Downside Case – Forecast Assumptions
- Net Income: Reduction by $25m Per Year
- Common Dividends: Payout Value Decline of $2m Per Year
In the “Upside Case”, the ending retained earnings balance increases from $240m in Year 0 to $440m by Year 5 – reflecting how management’s decision to retain a greater proportion of its net income has a net positive impact on the retained earnings balance.
As for the “Downside Case”, the ending retained earnings balance declined from $240m in Year 0 to $95m by the end of Year 5 – even with the company attempting to offset the steep losses by gradually cutting off the dividend payments.