What are Retained Earnings?
Retained Earnings represent 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.
How to Calculate Retained Earnings?
The retained earnings (RE) of a company are defined as the profits generated since inception, not issued to shareholders in the form of dividends.
The steps to calculate a company’s retained earnings in the current period are as follows.
- Determine Beginning Retained Earnings Balance: The process of calculating a company’s retained earnings in the current period initially starts with determining the prior period’s retained earnings balance, i.e. the beginning of period.
- Add Net Income: From there, the company’s net income – the “bottom line” of the income statement – is added to the prior period balance. The prior period balance can be found at the beginning of period balance sheet, whereas the net income is linked to the current period income statement.
- Subtract Dividends: In the final part of the roll-forward schedule, the issuance of dividends to equity shareholders is subtracted to arrive at the current period’s retained earnings balance, i.e. the end of the period. The intuition for deducting dividends in the retained earnings formula is that if a company were to decide to pay dividends to its shareholders, the proceeds come out of the company’s net income (and thus, retained earnings).
In effect, the equation calculates the cumulative earnings of the company post-adjustments for the distribution of any dividends to shareholders.
Retained Earnings Formula
The formula for calculating retained earnings is as follows.
- Prior Retained Earnings: The ending retained earnings balance from the prior period, which is recorded in the shareholders’ equity section of the balance sheet.
- Net Income: The net income is the accrual-based accounting measure of profitability and found on the income statement (i.e. the “bottom line”). Each period, the portion of a company’s net income not paid out as shareholder dividends flows into its retained earnings balance – hence, net income is added to the prior retained earnings account.
- Dividends: The issuance of a dividend, on a per-share basis, can be found in the section below the earnings per share (EPS) data on the income statement. In addition, the gross amount issued can be found on the cash flow statement (CFS) in the cash from financing section.
What is a Good Retained Earnings?
Generally speaking, a company with more retained earnings on its balance sheet is more profitable, since higher retained earnings represent more net earnings and fewer distributions to shareholders (and vice versa).
If the retained earnings balance is gradually accumulating in size, this demonstrates a track record of profitability (and a more optimistic outlook).
In contrast, if a company has consistently incurred substantial losses at the net income line item (i.e. 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 balance could also result from an aggressive dividend payout – e.g. dividend recapitalization in LBOs.
From a more cynical view, even positive growth in a company’s retained earnings balance could be interpreted as the management team struggling to find profitable investments and opportunities worth pursuing.
How to Interpret Retained Earnings?
There are numerous factors that must be taken into consideration to accurately interpret a company’s historical retained earnings.
- Company Lifecycle: One influential factor 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, so the company decides that the best course of action is to allocate the “excess” cash towards paying shareholders via dividends.
- Growth Opportunities: For mature companies, the available opportunities to place capital for expansion and to drive growth become more limited (or the risk profile does not meet the return hurdle). Thus, these sorts of low-growth companies are most likely to pay dividends to shareholders. With that said a high-growth company with minimal free cash flow will conversely re-invest toward extending its growth trajectory (e.g. research and development, capital expenditures).
- Profit Margins: Another factor to consider is the profitability of a company, as for growth-oriented companies in hyper-competitive industries, the market participants probably could not afford to issue dividends to shareholders in the first place, even if they wanted to compensate shareholders.
- Dividend Policy: 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 retention, 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.
- Cyclicality: Furthermore, the cyclicality of the industry can also be a contributing factor, i.e. 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.
How to Find Retained Earnings on the Balance Sheet?
The screenshot below is the income statement of Apple (AAPL) for the fiscal year ending 2022. The dotted red line in the shareholders’ equity section of the balance sheet is where the retained earnings line item can be found.
Apple Shareholders’ Equity Section of Balance Sheet (Source: 10-K)
Retained Earnings Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Operating Assumptions
Operating 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 balance – for instance, Year 0’s ending balance is $240m.
- 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)
2. Retained Earnings Forecast
In the next step, we’ll forecast the metric 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
3. Retained Earnings Calculation Example (Upside Case)
In the “Upside Case”, the ending 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.
4. Retained Earnings Calculation Analysis (Downside Case)
As for the “Downside Case”, the ending 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.