Updated July 10, 2023
What is the Statement of Retained Earnings?
The term “statement of retained earnings” refers to the line item in the balance sheet that summarizes the movement in a company’s retained earnings during a given period.
The statement of retained earnings is either created as a separate document or appended with the income statement and balance sheet. It is prepared to benefit existing and prospective external stakeholders, such as investors and lenders.
Explanation of Statement of Retained Earnings
The statement of retained earnings for a given accounting cycle opens with the amount of the retained earnings at the start of the reporting period. Then, the net profit for the period after the payment of dividends is added to arrive at the amount of the retained earnings at the end of the reporting period.
Purpose of Statement of Retained Earnings
The statement of retained earnings is a useful linkage between the income statement and the balance sheet as it records the net income transfer after dividends from the income statement to the shareholders’ equity in the balance sheet. In addition, the amount of retained earnings represents the internal fund available for purchasing new equipment, R&D expenses, or other business activities that could induce further growth to achieve even more earnings.
Examples of Statement of Retained Earnings
Example #1
Let us take the example of ZXC Inc. to illustrate the concept of retained earnings. In 2019, the company generated a net profit of $40,000 and decided to pay out a dividend of $8,000 to the shareholders. Next, determine the amount of retained earnings at the end of the year if, at the start of the year, the retained earnings were $120,000.
Solution:
Given, Opening retained earnings = $120,000
Dividend paid = $8,000
Net profit = $40,000
Now, the amount of retained earnings at the end of the year can be calculated as,
Closing Retained Earnings = Opening Retained Earnings + Net Profit – Dividend Paid.
- Closing Retained Earnings = $120,000 + $40,000 – $8,000
- Closing Retained Earnings = $152,000
Therefore, the retained earnings at the end of 2019 were $152,000.
Example #2
Let us use SDF Inc.’s example to compute the dividend payout ratio using the concept of retained earnings. The company’s retained earnings at the start and end of the year were $175,000 and $195,000, generating a net profit of $30,000. Determine the dividend payout ratio in this case.
Solution:
Given, Opening retained earnings = $175,000
Closing retained earnings = $195,000
Net profit = $30,000
The calculation for the dividend Paid is as below:
Dividend Paid = Opening Retained Earnings + Net Profit – Closing Retained Earnings.
- Dividend Paid = $175,000 + $30,000 – $195,000
- Dividend Paid = $10,000
The calculation for the dividend Payout Ratio is as below:
Dividend Payout Ratio = Dividend Paid / Net Profit
- Dividend Payout Ratio = $10,000 / $30,000
- Dividend Payout Ratio = 33.3%
Therefore, the company’s dividend payout ratio for the year was 33.3%.
Setting up Statement of Retained Earnings
You should follow the steps below to set up a statement of retained earnings.
- Step 1: The retained earnings balance at the end of the previous reporting period is carried over as the balance at the beginning of the current reporting period.
- Step 2: Add the net income generated during the reporting period to the retained earnings balance at the beginning of the period.
- Step 3: Finally, deduct the number of dividends paid to the shareholders from the summation of the retained earnings balance at the period’s beginning and the period’s net income to calculate the retained earnings balance at the end.
Uses of Statement of Retained Earnings
Some of the uses are as follows:
- Companies use statements of retained earnings to keep track of the internal fund available for expanding their operations. The expansion projects may include launching a new product line, building a new plant, upgrading current infrastructure, etc.
- It is also used in the distribution of profit among the shareholders.
- The trend in the statement of retained earnings can indicate the growth of a company’s operation.
Advantages
Some of the major advantages are as follows:
- The retained earnings are the first and easiest source of capital without any additional cost of funding.
- A healthy accumulated retained earnings over time indicates a stable business and the company’s strong financial position.
- A company can dive into the retained earnings to pay dividends to the shareholders when it cannot generate enough profit.
Disadvantages
Some of the major disadvantages are as follows:
- A company may resort to careless spending of funds if the purpose of retained earnings is not defined clearly.
- A company might end up over-capitalizing due to huge accumulated retained earnings if it follows a conservative dividend policy.
Conclusion
So, the statement of retained earnings is a very important aspect of a company’s financial reporting as it reflects the undistributed portion of the profit plowed back into business for internal funding and fixed and working capital requirements.
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