Retained earnings show how much profit a business has kept over time instead of paying it out to its owners. You will see the line on a corporation’s balance sheet, and lenders and investors often look at it to understand a company’s history. It is also one of the most misunderstood numbers in small business accounting, because retained earnings are not the same as cash.
This guide explains what retained earnings are, how to calculate them, and how they relate to the rest of your financial statements.
What Are Retained Earnings?
Retained earnings are the total net profits a corporation has earned since it started, minus the total amount it has paid out to shareholders as dividends or distributions. The profit that stays in the business can be used to buy equipment, pay down debt, build a cash reserve, or fund growth.
Retained earnings are part of equity, the owners’ share of the business. They appear in the equity section of the balance sheet.
The U.S. Securities and Exchange Commission’s Beginners’ Guide to Financial Statements explains how a company’s equity reflects the profits it keeps and reinvests rather than paying out to its owners.
The Retained Earnings Formula
Ending Retained Earnings = Beginning Retained Earnings + Net Income − Dividends or Distributions
- Beginning retained earnings come from the end of the previous period.
- Net income comes from your profit and loss statement. If the business had a net loss, you subtract it instead.
- Dividends or distributions are amounts paid out to the owners during the period.
A Simple Example
Here is a hypothetical example for a small corporation over three years.
| Year | Beginning Retained Earnings | Net Income (Loss) | Distributions | Ending Retained Earnings |
|---|---|---|---|---|
| 1 | $0 | $40,000 | $10,000 | $30,000 |
| 2 | $30,000 | $55,000 | $20,000 | $65,000 |
| 3 | $65,000 | ($15,000) | $0 | $50,000 |
In year 3, the loss reduces retained earnings even though no money was paid out. If losses and distributions over time are larger than total profits, retained earnings become negative. This is often called an accumulated deficit.
Retained Earnings Are Not Cash
A business can have large retained earnings and very little cash. Profits kept in the business may already have been spent on equipment, inventory, or loan payments, or may still be tied up in unpaid customer invoices. To see what happened to your cash, look at the cash flow statement. For a quick look at short-term financial health, see working capital.
Do Sole Proprietors Have Retained Earnings?
Not usually under that name. Retained earnings are a corporate concept. A sole proprietorship, and a partnership or LLC taxed as a partnership, usually tracks the owners’ stake in an owner’s equity or capital account instead. Profits add to the account, and owner withdrawals reduce it. The idea is similar, but the labels are different. See owner’s draw vs. salary for how withdrawals work.
Corporations, including S corporations, and LLCs that are taxed as corporations show retained earnings on their balance sheets. For more on structures, see sole proprietorship vs. LLC vs. S corp.
How Retained Earnings Are Updated in Your Books
At the end of each year, the balances in your revenue and expense accounts are closed out. The resulting net income or loss is moved into retained earnings, and the income and expense accounts start the new year at zero. Most accounting software does this automatically. Distributions or dividends paid during the year reduce retained earnings.
Checking this account is part of a good year-end accounting checklist. If the opening balance does not match last year’s ending balance, something was changed in a prior period and should be reviewed.
Why Retained Earnings Matter
- They show the business’s track record. Growing retained earnings usually mean the company has been profitable and has kept money in the business.
- Lenders look at them. A history of reinvested profit can make a business look more stable.
- They help with planning. Comparing profits with distributions shows whether owners are taking out more than the business earns.
Frequently Asked Questions
Are retained earnings an asset?
No. Retained earnings are part of equity on the balance sheet. The assets they helped pay for, such as cash or equipment, appear separately in the assets section.
Can retained earnings be negative?
Yes. When total losses and distributions are larger than total profits, the balance is negative and is often called an accumulated deficit.
What is the difference between net income and retained earnings?
Net income is the profit for one period. Retained earnings are the running total of profits kept in the business since it began.
Conclusion
Retained earnings tell the story of how much profit a corporation has kept over its life. Use the formula to check the balance each year, remember that retained earnings are not cash, and review them alongside your other financial statements for the full picture.