One of the key financial indicators lenders and investors look at when evaluating a business is retained earnings. Retained earnings show lenders and investors how you handle your net profits, specifically the amount of profits you reinvest in your business. In this article, you’ll learn the importance of retained earnings for your business.
What are retained earnings?
Annual profits that you reinvest in your business are retained earnings. The principle is simple – when you earn a net profit (calculated as revenues minus expenses), you have two choices:
- Take profits as a cash distribution and/or
- Reinvest profits into the business
Your retained earnings grow each year by the amount of profit you chose to reinvest. These cumulative profits reinvested in your business – retained earnings – are reported on your balance sheet in the equity section.
The Retained Earnings Equation
Beginning retained earnings (Jan 1)
+ Profit (Loss)
– Cash distributions to owners
Ending retained earnings (Dec 31)
How do retained earnings work?
Let’s say you opened a business on January 1, 2015. By the end of 2015, you earned $20,000 in profit (earnings). You decide to:
- Reward yourself with a $5,000 cash distribution for all your hard work and
- Reinvest the remaining $15,000 to make improvements to the business.
At the end of the year, your retained earnings look like this:
Retained earnings summary
|Beginning retained earnings (Jan. 1)||$ 0|
|+ Profit (Loss)||+ $20,000|
|– Cash distributions to owner||– $5,000|
|Ending retained earnings (Dec. 31)||$ 15,000|
Why do lenders and investors care about retained earnings?
The way you handle profits over time is an important factor for lenders and investors. They generally expect to see your retained earnings grow over time and add value to your business. Positive retained earnings reflect a commitment to sustain and grow a business, whether it is through investing in new equipment or technology, or expanding the business operation. Negative retained earnings can indicate one of two things: (1) the business has experienced more losses than profits over time or (2) the owner is more focused on taking cash distribution than investing in future business growth. Lenders and investors generally avoid dealing with companies that have negative equity.
Did you know…
The words “earnings” and “profits” mean the same thing. Therefore the terms “retained earnings” and “retained profits” both signify profits that were reinvested in a business.