There are many different factors to consider if you want to analyze your business’ growth. Two of the most important measures to keep a close eye on are retained earnings and revenue. While these two figures go hand-in-hand, they measure different financial values of your company.
Your business’ financial statement says a lot about the health and prospects of your company. Here’s what you need to know about retained earnings and how they’re different from revenue.
What is Revenue?
Looking at your business’ income statement, revenue will typically be the first number that you see. Revenue is also sometimes referred to as gross sales or net income. It’s the go-to figure for determining a company’s financial performance in a set period of time. Revenue is all of the income that is earned by the company. The figure is generated before overhead costs and operating expenses are deducted.
What Are Retained Earnings?
Retained earnings are a percentage of a company’s revenue that is retained and set aside for future use. Retained earnings can be used for various things such as:
- Paying off business debt
- Paying dividends to shareholders
- Expanding the company (ie. buying more office space)
- Upgrading office equipment
When deciding what to do with the retained earnings in your company, there are many factors to consider.
The Relationship between Revenue & Retained Earnings
So what’s the connection between revenue and retained earnings? Revenue is the profit that a business earns during a period. Net income is determined by subtracting business costs, such as payroll, overhead, utilities, rent, depreciation, debt interest, and sales costs.
Business owners can choose to pay out net income to shareholders or to reinvest it back into the company. But, when a business owner takes neither one of these routes, the funds become retained earnings.
In simplest terms, you can view retained earnings as a business savings account. The money available will change based on time, net income changes, and other monetary factors.
How Retained Earnings are Calculated
When looking at your company’s balance sheet, you’ll find retained earnings listed under the shareholders’ equity section. If you’re wondering how to calculate retained earnings, the calculation is pretty simple.
To calculate the number, take the beginning retained earnings balance, add revenue for the set period, and then subtract any dividends that have been paid out to stakeholders. In mathematical form: Retained Earnings (RE) = RE Beginning Balance + Revenue – Dividends.
Here’s an example of how to calculate retained earnings with a hypothetical company.
- Beginning retained earnings balance of $7,000
- Revenue total of $5,000 for the set period
- Dividends paid in the amount of $3,000
- Retained Earnings = $7,000 + $5,000 – $3,000
In this scenario, the company’s retained earnings for the period would be $9,000. Make note that at times, retained earnings can dip into the negative. This is most common if a company has paid a large number of dividends to shareholders or experienced a slump in profit.
Why Retained Earnings Matter
A company’s retained earnings statement is important for many reasons. First, the number shows how much equity shareholders collectively hold in the company. In essence, retained earnings are the total amount of money that a business’ shareholders are entitled to. But, shareholders can only receive retained earnings through a dividend that can be paid out in cash or stock.
Shareholders can take the retained earnings number and divide it by the number of outstanding shares. This allows each shareholder to calculate how much money a single share is worth.
Retained earnings are also important to the board of directors as the figure indicates how much money is available to redistribute to shareholders or to invest back into the company. Ultimately the board is responsible for making the decision of how to best utilize retained earnings.
Investors and creditors also care about retained earnings. Investors look at retained earnings statements when considering which firm to invest in as it gives them a ballpark idea of how much they can expect as a return on investment.
Creditors look at retained earnings as a performance measure when reviewing a business’ credit application. Creditors look for high retained earnings, which indicate that the company is profitable and is unlikely to have any issue repaying the money that it has borrowed. A company with minimal retained earnings may be seen as risky.
Understanding the difference between revenue and retained earnings is important so that you can best understand the financial health and growth of your company. Closely tracking these two numbers is also important so that you can make the best business decisions for the future success of your brand.