Statement of Retained Earnings

The Statement of Retained Earnings is a financial report that details the changes in a company’s retained earnings over a specific period. Retained earnings are the cumulative net income of the company after it has paid out dividends to shareholders. The statement reconciles the opening and closing retained earnings for the period, incorporating net income from other financial statements, and helps analysts understand how profits are utilized. 

Also known as the Statement of Owner’s Equity, Equity Statement, or Statement of Shareholders’ Equity, this statement is created in accordance with generally accepted accounting principles (GAAP).

Statement of Retained Earnings Formula:  

To construct a statement of retained earnings, we employ this formula: 

This equation accounts for the flow of earnings into and out of the company. Retained earnings will decrease if the company is loss making or pays dividends. Any nearly earned net income will grow the retained earnings. 

Why Retained Earnings Matter 

The statement of retained earnings provides solid support to the company’s financial structure: 

1. A robust retained earnings profile can reinforce market faith and that the company continues to grow profitably 
2. The retention ratio offers insight into a company’s strategy for deploying profits back into operations 
3. It reveals the balance between rewarding shareholders and fuelling internal growth 
4. High retention often signals expansion plans or industry-specific capital intensity 
5. Retained earnings can finance growth without incurring debt, optimizing the company capital structure 
6. Strong retained earnings can fund strategic purchases without diluting ownership 

In M&A transactions and valuation assignments, these insights into uses of profits are invaluable. They allow analysts to gauge a company’s self-funding abilities, dividend sustainability, and potential for leveraged growth—all critical factors in determining enterprise value and transaction viability. 

Components of Statement of Retained Earnings 

A statement of retained earnings contains several key elements: 

1. Time Frame: the specific period under examination 
2. Beginning Balance: the retained earnings carried forward from the previous period 
3. Net Income/Loss: profit or deficit from the income statement 
4. Dividends: shareholder payouts that reduce retained earnings 
5. Adjustments: any corrections or changes to prior periods 
6. Ending Balance: the final retained earnings figure after all calculations 

How to Prepare a Retained Earnings Statement 

Here’s a step-by-step guide on how to prepare one, with an example for better understanding. 

Retained Earnings Formula 

Steps to Prepare a Retained Earnings Statement 

1. Identify the Beginning Retained Earnings: start with the retained earnings balance from the previous period (This information is found on the previous period’s balance sheet) 
2. Add Net Income: obtain the net income for the current period from the income statement (This is the profit earned after all expenses have been deducted) 
3. Subtract Dividends: deduct any dividends paid out to shareholders during the period (This information can be found in the company’s financial records or cash flow statement) 
4. Calculate Ending Retained Earnings: use the formula to determine the retained earnings balance at the end of the period 

Example of Preparing a Retained Earnings Statement 

Let’s take a fictional company, XYZ Corp., to illustrate the preparation of a Retained Earnings Statement. 

1. Beginning Retained Earnings: Assume XYZ Corp. has beginning retained earnings of $100,000 as of January 1, 2023 
2. Net Income: For the fiscal year ending December 31, 2023, XYZ Corp. reports a net income of $50,000 
3. Dividends Paid: During the same period, XYZ Corp. paid out $10,000 in dividends to its shareholders 

Using the formula, the Ending Retained Earnings calculation would be: 

Ending Retained Earnings = $100,000 + $50,000 − $10,000 = $140,000 

This would be shown on the Retained Earnings Statement for XYZ Corp. for the year ending December 31, 2023: 

This statement shows that XYZ Corp. retained $140,000 of its earnings at the end of 2023, indicating a reinvestment of profits back into the company, which can be used for growth, debt repayment, or other business activities. 

Download the Statement of Retained Earnings template from the free resources section and learn how to collate the information necessary to complete it with our easy-to-use guide. 

Benefits of Using the Statement of Retained Earnings 

The Statement of Retained Earnings provides several advantages: 

• It offers a snapshot of how much profit is being retained and reinvested, indicating the company’s growth potential and financial stability 
• Investors can understand the company’s approach to dividend distribution versus profit retention 
• It helps track profitability trends over time and assess how effectively earnings are utilized 
• Management can make strategic decisions regarding reinvestment and dividend payouts based on the retained earnings 

Retention vs. Distribution 

Company management will have to weigh up the potential benefits of earnings retention versus dividend distribution. Excessive hoarding of profits can suggest inefficient capital allocation, while overpayment of dividends may necessitate debt or equity issuance for basic operational needs. The statement of retained earnings lays bare this delicate equilibrium. 

The retention ratio quantifies the amount of earnings retained by the company to grow the business rather than returning to investors via dividends. The formula is detailed below: 

In the case of XYZ Corp. the retention ratio would be ($50,000 – $10,000) / $50,000 = 80%. This would tell us that the company is paying out dividends but still holding onto a significant portion of its annual earnings. Analysts can compare this to prior years to see if there are any points where the dividend payments are proving difficult to service.  

Companies who don’t typically pay dividends, such as tech companies or those in high growth sectors would tend to have higher retention ratios. Mature companies who have reached steady-state operations would tend to return more cash to shareholders as expansion has been completed and would therefore have a lower retention ratio. 

Conclusion 

The statement of retained earnings, though often overshadowed by its counterparts, is a testament to the engineering principles underlying financial reporting. It ensures that the ebbs and flows of corporate profits are meticulously tracked, providing a clear view of how earnings are reinvested or returned to shareholders. 

In financial analysis this is a valuable tool when looking at company operations for an M&A perspective. It’s not merely a record of past decisions but a blueprint for future financial architecture and the strength of company management. Analysts and decision-makers can use this to better understand a company’s fiscal foundation and ensure that each financial move reinforces the structure rather than compromises it.