The statement of retained earnings, also known as the retained earnings statement, is a financial statement that shows the changes in a company’s retained earnings account for a period of time.
This statement is used to reconcile the beginning and ending retained earnings for a specified period when it is adjusted with information such as net income and dividends. It is used by analysts to figure out how corporate profits are used by the company.
It shares a lot of familiarities with the statement of changes in equity, but it only shows how retained earnings have changed during the period. The statement of retained earnings includes the following basic elements:
- Beginning balance of retained earnings
- Corrections for previous errors along with any tax effect
- Net income
- Dividends or withdrawals by the owner
When dividends are declared in a specific period, they must be subtracted in the statement of retained earnings of that period. It does not matter whether the payment of dividends has been made or not.
This statement of retained earnings appears as a separate statement or it can also be included on the balance sheet or an income statement. The statement contains information regarding a company’s retained earnings, also including amounts distributed to shareholders through dividends and net income. An amount is set aside to handle certain obligations other than dividend payments to shareholders, as well as any amount directed to cover any losses. Each statement covers a specified period of time, usually a year, as noted in the statement.
Purpose of Retained Earnings Statement
Retained earnings represent an incredibly beneficial link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements.
The purpose of retained earnings can be diverse and may include buying new property & machinery, paying off debt, investing in research and development, and other activities that could increase the growth of the company and result in potential profits. This reinvestment back into the company usually intends to achieve more profits in the future.
Importance of Retained Earnings Statement
The statement of retained earnings has great importance to investors, shareholders, and the Board of Directors.
Importance to Investors
A company releases its statement of retained earnings to the public to raise market and shareholder confidence. Investors can judge the health of a company by evaluating this statement. The statement is of great importance to individuals within the organization as well. Outside investors can gauge the potential earnings of a company by analyzing the statement of retained earnings.
Importance to Board
Essentially, a statement of retained earnings is crucial for a company’s growth, as it gives the Board of Directors confidence that the company is well worth the investment in both money and time. The Board of Directors are responsible to shareholders. Ultimately, they have to make the decision to keep the shareholders happy. Retained earnings tell the Board how much money the company has, and enables them to make an informed decision.
Importance to Shareholders
Using the retained earnings, shareholders can find out how much equity they hold in the company. Dividing the retained earnings by the no. of outstanding shares can help a shareholder figure out how much a share is worth.
Importance to Creditors
Creditors view this statement as well, as they want to look at several performance measures before they can issue credit to a company. Low or negative retained earnings indicate that the company may have problems repaying its debt. This may result in the creditors choosing not to provide credit to these businesses or charge them a higher interest rate to compensate for the risk.
Retained Earnings Formula
Retained earnings can be calculated using the balance sheet. A balance sheet consists of assets, liabilities, and stockholder equity. This balance sheet ensures that the assets on the books of a company are equal to the sum of the company’s liabilities and stockholder equity.
Example of a Retained Earnings Statement
Retained Earnings as a Long-term Source of Funds
Retained earnings can help a company increase its stock value, assure organizational sustainability and provide budgets for important activities like research & development and expansion without increasing your debt. Retained earnings are added to a company’s balance sheet, increasing stockholder equity, and therefore increasing stock value. This increased stock price will usually attract new investors, who would want a share in the future profits.
Retained earnings give a company the freedom to expand in whichever way they see fit, ensuring the original vision of the company is kept intact.
Negative Retained Earnings
Retained earnings, sometimes, can be negative as well and when a company has a net loss, it has to be recorded in the retained earnings. This loss can also be referred to as “accumulated deficit” in the books. If this loss is greater than the amount of profits previously recorded as retained earnings, then it is considered to be negative retained earnings.
A profitable company can also experience negative retained earnings. This can happen when the company pays out more dividends than money is available. This is usually an early indicator of a potential bankruptcy as this can imply a series of losses over the years.
Conclusion
In conclusion, the statement of retained earnings is more of a summary of the financial health of the company. It shows the amount that is retained from profits after paying shareholders their dividends over a specified period of time.
The statement gives details of retained earnings at the beginning of the current year, net income or net loss generated in the current year and the dividend paid throughout the current year. As a result, the retained earning’s amount carried forward to the balance sheet is also shown here. It is a very effective tool for various stakeholders in assessing the health of the company if used correctly.
FAQs
1. What is a statement of retained earnings?
It is a summary of the financial health of the company over a period. The statement shows the retained earnings at the beginning of the year, net income or loss generated in that year, and how much was paid out in dividends. As a result, it also shows the retained earning amount carried forward to the balance sheet.
2. How do you prepare a statement of retained earnings?
The statement of retained earnings can be prepared from the company's balance sheet. The assets, liabilities, and stockholder equity are all considered to ensure the assets match the sum of liabilities and stockholder equity. From this, the net income or loss is calculated and then subtracted from the dividends paid out to get the retained earnings.
3. Why is the statement of retained earnings important?
The statement is important as it shows the financial health of the company and can help various stakeholders make informed decisions about the company. It also helps track how much profit has been retained over a period and can be an early indicator of potential bankruptcy.
4. What does the statement of retained earnings show you?
The statement of retained earnings shows you the financial health of the company and how much profit has been retained over a period of time. It can also be an early indicator of potential bankruptcy. As a result, it is an important tool for various stakeholders in assessing the health of the company.
5. Which financial statement is used by corporations instead of a statement of retained earnings?
The income statement is used by corporations in place of a statement of retained earnings. This statement shows the company's revenue, expenses, and net income over a period of time. It can be used to track how well the company is doing and whether it is making a profit or not.
