Retained earnings might not be the flashiest term on your financial statements, but don’t underestimate their importance. For small business owners, understanding retained earnings can provide key insights into your company’s profitability, financial health, and strategic flexibility. Whether you’re trying to secure funding, plan for the future, or simply make better decisions, mastering the concept of retained earnings is indispensable.
This guide will break down what retained earnings are, how to calculate them, and why they matter. It’s time to take the mystery out of this vital financial term so you can make smarter, more informed business decisions.
What Are Retained Earnings?
Retained earnings represent the cumulative net income your business has earned, minus any dividends or shareholder distributions you’ve paid out. Think of it as the money your business has decided to keep and reinvest for future growth, rather than distributing to owners.
Here’s the formula for calculating retained earnings:
Retained Earnings = Beginning Retained Earnings + Net Income − Dividends
Retained earnings aren’t just numbers on a balance sheet—they can tell the story of your business. Are you growing steadily? Are you reinvesting profits wisely? Or are you overextending with distributions and losing momentum? Understanding retained earnings helps answer these questions.
How Retained Earnings Fit Into Your Financial Statements
Each accounting period, your revenue and expenses from the income statement are “closed out” into retained earnings. This process allows the next period’s income statement to start fresh.
Most financial statements include a Statement of Retained Earnings, which shows how this account has changed over time. This statement reveals:
- Beginning retained earnings at the start of the period
- Net income (or loss) during the period
- Dividends or distributions paid out
- Ending retained earnings for the period
For example, if your business started the year with $50,000 in retained earnings, earned $20,000 in net income, and paid $10,000 in dividends, your retained earnings at year-end would total $60,000 ($50,000 + $20,000 − $10,000). It’s simple math, yet incredibly powerful when it comes to understanding your financial foundation.
Why Are Retained Earnings Crucial?
Retained earnings are often seen as a key indicator of a business’s profitability, stability, and financial health. Here are three main ways they can impact your small business:
1. Attracting Investors and Lenders
Investors and lenders carefully monitor retained earnings to assess your company’s performance and long-term potential. Growing retained earnings signify that your business is profitable and mindful about reinvesting resources. This can make your business an attractive option for funding.
Additionally, retained earnings are part of owners’ equity, a crucial metric used by stakeholders to calculate financial ratios like:
- Return on Equity = Net Income / Owners’ Equity
- Debt-to-Equity Ratio = Total Liabilities / Owners’ Equity
- Retention Ratio = Retained Earnings / Net Income
Lenders often include these ratios in loan covenants, meaning any violation could result in penalties or default. Strong retained earnings can help you stay compliant and demonstrate stability.
2. Funding Strategic Growth
Retained earnings give you options. Whether you want to invest in new equipment, expand your workforce, fund marketing campaigns, or explore new markets, having a healthy retained earnings balance ensures your business has the resources to take action without needing external funding.
For example, a small retail business with $100,000 in retained earnings could open a second store or purchase inventory for peak seasons without taking on debt—a move that might otherwise strain cash flow.
3. Shareholder Expectations and Distributions
Dividends or distributions are a balancing act for any business. While shareholders appreciate payouts, retaining too little earnings can limit your ability to grow. On the flip side, holding onto excessive earnings may lead to scrutiny from the IRS for C corporations under federal accumulated earnings tax provisions.
Understanding the strategic purpose of retained earnings helps strike the right balance—keeping both shareholders and your business’s future growth in mind.
Managing Retained Earnings Strategically
How Should You Use Retained Earnings?
Profitable businesses often face tough decisions about how to allocate retained earnings. Below are some common options:
- Build Cash Reserves: Reinforce your financial cushion for unexpected challenges or opportunities.
- Repay Debt: Lower interest payments and improve your debt-to-equity ratio.
- Invest in Growth: Fund strategic initiatives like launching new products, improving technology, or expanding operations.
- Distribute to Shareholders: Provide consistent returns to stakeholders via dividends.
Your approach will depend on several factors, including your business stage, shareholder expectations, and anticipated market conditions. For example, a startup may reinvest heavily to gain market share, while a mature company may prioritize steady dividends to maintain shareholder trust.
Beware of Tax Implications
If you’re a C corporation, managing retained earnings requires extra caution. The IRS imposes a tax on unreasonable accumulated earnings to deter businesses from avoiding shareholder dividends to shelter tax liabilities. Consult a tax professional who can help you determine appropriate balances and avoid IRS scrutiny.
Communicating Value
Retained earnings aren’t just an internal metric—they’re a signal to external stakeholders. If you plan to sell your business or attract investors, a strong retained earnings history can indicate sound financial health and strategic vision. This makes your business more desirable and trusted in competitive markets.
How SD Mayer Can Help
Many small business owners struggle to fully grasp or utilize retained earnings to their advantage. That’s where we come in. At SD Mayer & Associates, we specialize not just in calculating numbers but in helping you make smarter financial choices. From creating a clear financial plan to helping you balance dividends with growth, we offer customized solutions tailored to your business goals.
When year-end approaches, critical decisions around allocating retained earnings can make or break your plans for future growth. Whether you’re ready to prepare for board meetings, monitor loan compliance, or simply find the most effective ways to reinvest in your business, we’re here to help guide the way.
Contact us today for a consultation and take the next step toward financial
DISCLAIMER:
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The services of an appropriate professional should be sought regarding your individual situation.
