How to calculate retained earnings

To calculate retained earnings, you start with total earnings retained by the business from previous periods, add any profits (or subtract losses) earned during the current period, and then subtract any dividends paid to shareholders. 

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This calculation shows how much of your business’s earnings remain available for reinvestment or as a financial cushion.

What are retained earnings?

Retained earnings represent the portion of your company’s profits that are not distributed as dividends. Instead, these funds are reinvested into the business to support growth initiatives, daily operations, or unexpected expenses. Think of retained earnings as the company’s financial safety net, growing with profits and shrinking when losses occur or dividends are paid out.

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Over time, retained earnings provide a snapshot of how much profit has been reinvested into the company. They reflect the financial health and reinvestment strategy of the business, making them an essential metric for companies of all sizes.

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For many businesses, retained earnings are used to:

• Invest in growth opportunities, such as expanding into new markets or launching products.
• Purchase fixed assets like machinery or property to increase capacity.
• Reduce debt and meet other financial obligations.
• Maintain adequate working capital for day-to-day expenses.
• Build a reserve to manage economic uncertainties or unexpected costs.

How to find retained earnings

You can find the retained earnings line item on the equity section of the Statement of Financial Position, commonly known as the balance sheet. Here are the figures to look out for:

• Starting retained earnings: This figure represents all the retained earnings accumulated up to the end of the prior period. It is located in the equity section of the balance sheet under “Retained Earnings.” This figure serves as the baseline for calculating changes in retained earnings during the current period.
• Net income or loss: Your net income (or net loss) reflects the company’s profitability for the current period and is found on the income statement. Net income increases retained earnings, while a net loss reduces it. This figure is a direct indicator of how well the company has performed during the period.
• Dividends paid: Cash dividends reduce the retained earnings balance and are typically detailed in the financing activities section of the cash flow statement or disclosed in the notes to the financial statements. The retained earnings formula generally accounts for cash dividends. Businesses may also issue stock dividends, which do not directly reduce retained earnings but instead reallocate amounts from retained earnings to paid-in capital, leaving total equity unchanged.

How to calculate retained earnings

Here’s what the retained earnings formula looks like:

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Beginning Retained Earnings + Net Income (or Net loss) for the period − Dividends Paid ± Adjustments = Ending Retained Earnings (RE)

Step 1: Identify beginning retained earnings/current retained earnings

The amount of retained earnings your company had at the end of the previous period is your starting point. This is also known as "retained earnings brought forward." This figure, found in the equity section of the balance sheet, serves as the baseline for the calculation.

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For instance, if your company reported $100,000 in retained earnings at the end of the prior year, this becomes your beginning retained earnings for the current period.

Step 2: Add net income (or subtract net loss)

Factor in how the company performed during the period. If your business made a profit, you will add it to your starting retained earnings. If your company incurred a loss, you will subtract that instead. You can find these figures on the income statement, also known as the profit and loss statement. Here’s the formula to do that:

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Adjusted Retained Earnings = Beginning Retained Earnings + Net Income (or - Net Loss)

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Let’s say your starting retained earnings are $100,000, and your company earned $50,000 in net income; the adjusted retained earnings would be $150,000.

Step 3: Subtract dividends paid

If your business pays cash dividends, you will need to subtract any dividend paid during the accounting period (i.e., the quarter or year) from the adjusted retained earnings. If your business doesn’t pay dividends, you can simply skip this step and replace the dividend portion in the formula with $0. 

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Retained Earnings = Adjusted Retained Earnings − Dividends Paid

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Continuing with the example, if your company paid out $20,000 in dividends, the calculation would be:

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$150,000 - $20,000 = $130,000

Step 4: Account for adjustments (if necessary)

Adjustments may be required to ensure that your retained earnings accurately reflect your business's financial position. These adjustments tend to arise from correcting accounting errors, implementing changes in accounting policies, or reclassifying previous entries.

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For example, accounting errors from prior periods, such as misreported income or expenses, must be corrected. If a $5,000 revenue item was mistakenly omitted in the previous period, this amount would need to be added to retained earnings. Conversely, if an expense of $3,000 was understated, that amount would need to be subtracted from retained earnings to reflect the actual financial impact.

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Adjustments may also occur due to changes in accounting policies. For instance, if your business switches from straight-line depreciation to the declining balance method for fixed assets, the cumulative effect of this change on prior periods would need to be accounted for. If the new method increases cumulative depreciation by $7,000, retained earnings would be reduced by that amount to reflect the policy change.

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When making adjustments, update the retained earnings account directly and document the changes in your financial statements. For instance, if your retained earnings were $130,000 and you identified an $8,000 expense that had been overlooked, your calculation would be:

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$130,000 - $8,000 = $122,000 (final retained earnings)

Example of retained earnings calculation

Consider a mid-sized manufacturing company specializing in eco-friendly packaging solutions. At the end of its first fiscal year, the company reports a net profit of $800,000. As the business is in its early stages and focused on scaling operations, it decides not to distribute any dividends. Instead, it reinvests the entire profit into the company.

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At the close of Year 1, the company’s retained earnings are straightforward:

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Beginning retained earnings: $0 (since it’s the first year of operations)
Net income: $800,000
Dividends paid: $0

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Retained earnings: $0 + $800,000 − $0 = $800,000

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In Year 2, the company launches a new product line targeting large retailers, which drives significant growth in demand. As a result, the company earns a net income of $1,500,000. To reward its employees for their hard work during a year of rapid growth, it distributes $300,000 in employee bonuses, classified as dividends.

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Here’s the retained earnings calculation for Year 2:

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Beginning retained earnings: $800,000
Net income: $1,500,000
Dividends paid: $300,000

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‍Retained earnings: $800,000 + $1,500,000 − $300,000 = $2,000,000

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Year 3 brings unexpected challenges. The company faces rising costs for raw materials and shipping due to supply chain disruptions. Additionally, demand decreases slightly as competitors enter the market, resulting in a net loss of $400,000. 

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Despite the difficulties, the company chooses to maintain investor and stakeholder confidence by distributing $150,000 in dividends. The business did not generate net income in the current period. As a result, the dividend is paid from prior retained earnings.

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During the same year, the company identifies an error in its Year 2 accounting records. An underreported operating expense of $100,000 needs to be corrected, requiring an adjustment to retained earnings. This ensures the financial statements comply with accounting standards.

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The retained earnings calculation for Year 3 is as follows:

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Beginning retained earnings: $2,000,000
Net loss: −$400,000
Dividends paid: $150,000
Adjustment: −$100,000

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Retained earnings: $2,000,000 − $400,000 − $150,000 − $100,000 = $1,350,000

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Despite the challenges of Year 3, the company still maintains $1,350,000 in retained earnings. These funds provide a financial cushion, enabling the business to explore cost-saving strategies, develop innovative products, and stabilize operations as market conditions improve.

Common mistakes when calculating retained earnings

One of the most common issues when calculating retained earnings is overlooking prior-period adjustments. These adjustments, such as correcting errors or revising estimates, often have a significant impact that’s underestimated. For instance, if a major expense from the previous quarter was understated, it can inflate retained earnings and create an inaccurate picture of the company’s financial health. This can lead to overestimating funds available for reinvestment or dividends, sometimes resulting in liquidity challenges down the road.

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Another common mistake is the use of incorrect net income figures. Since net income feeds directly into retained earnings, any error here will ripple through the entire calculation. To ensure accuracy, reconciling the income statement with source documents like invoices, contracts, and receipts is essential.

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Dividends are another area where missteps often occur. Forgetting to deduct dividends from retained earnings can leave stakeholders with the false impression that more funds are available than actually exist. This can lead to unrealistic expectations about reinvestment capacity or debt repayment.

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Adjustments related to changes in accounting policies or corrections of prior errors must also be accurately reflected. Failing to account for these changes not only leads to inaccuracies but can also create compliance issues or raise concerns during audits.

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Careful reconciliation of figures, regular reviews of prior-period adjustments, and diligent tracking of dividends ensure retained earnings calculations provide an accurate and reliable measure of a company’s financial position.

The role of retained earnings in business stability

Retained earnings may not be as flashy as cash flow or net profit, but they’re a key indicator of your business’s financial health and potential. This metric shows how well your business can grow, adapt, and sustain itself.

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Retained earnings provide a source of funding for growth and reinvestment. Instead of relying on loans or outside investors, a healthy balance allows businesses to expand product lines, purchase new equipment, or open additional locations. Unlike external funding, retained earnings come without restrictions, offering the flexibility to invest in opportunities on your own terms.

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They also contribute to financial stability. Strong retained earnings act as a safety net during slow seasons, unexpected expenses, or economic downturns. This financial cushion signals resilience, making your business more attractive to lenders and investors who value stability as much as profitability.

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For investors, retained earnings demonstrate responsible profit management. Beyond revenue numbers, potential investors look at retained earnings to assess whether profits are being reinvested wisely or squandered. A strong retained earnings balance reflects a business that is not only profitable but also sustainable and focused on long-term success.

Retained earnings vs. other financial metrics

Retained earnings often get grouped with metrics like net income or cash flow, but they serve a unique purpose. Here’s how they stack up against other financial figures:

1. Net income VS retained earnings

Net income is your "headline number" for profitability during a specific period. It shows whether the business earned more revenue than expenses or, in the case of a loss, the reverse. Retained earnings, on the other hand, represent the cumulative profits your business has kept over its entire history minus dividends paid to stakeholders.

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Think of net income as a snapshot—it’s a moment-in-time view of how profitable your business was during a specific period. Retained earnings, in contrast, show the long-term story of how much profit your business has retained and reinvested over time.

2. Cash flow VS retained earnings

Cash flow focuses on liquidity and the movement of cash into and out of the business. It answers questions like how much cash is available to pay bills, salaries, or suppliers. Retained earnings, by comparison, are more of an accounting measure—they reflect cumulative profit but include non-cash items like depreciation.

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A business can have strong retained earnings but still struggle with cash flow. For instance, a company might report significant retained earnings on its balance sheet but have limited liquidity due to unpaid invoices or investments tied up in long-term assets. Retained earnings are about profitability over time, while cash flow reflects real-time financial health.

3. Shareholder equity VS retained earnings

Retained earnings are one component of shareholder equity, which also includes paid-in capital and other reserves. Shareholder equity represents the net assets of the company—the value that remains after all liabilities are paid. It’s the ownership stake held by shareholders, founders, or partners.

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While shareholder equity provides a broad view of what stakeholders own, retained earnings focus specifically on how much profit has been reinvested into the business rather than distributed as dividends. So, equity paints the big picture of ownership, while retained earnings highlight the company’s reinvestment decisions.

How to optimize retained earnings with smarter financial tools

Accounting software like QuickBooks, Xero, or FreshBooks simplifies the tracking of income, expenses, and dividends, providing an organized and accessible view of financial data. It generates balance sheets that show starting retained earnings and income statements that display net income, both essential figures for calculating retained earnings. By automating these core reports, accounting software reduces manual errors and ensures calculations are based on accurate, up-to-date data.

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Another advantage of accounting software is its ability to maintain detailed records of transactions. Dividends, for instance, are tracked in real-time, ensuring they are accurately deducted from retained earnings. 

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A small business using Xero, for example, can log dividend payments directly into the platform, which are then reflected in the company’s balance sheet. Additionally, automated expense tracking categorizes costs like salaries, rent, and materials, ensuring that the net income feeding into retained earnings is precise. Without this level of organization, businesses risk miscalculations that could lead to flawed financial decisions.

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Beyond accounting software, financial automation tools enhance the process by addressing common inefficiencies and providing deeper insights. Ramp automates expense tracking and transaction recording, syncing directly with accounting platforms to ensure every entry is timely and accurate. 

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This eliminates delays and discrepancies in financial data, especially for businesses with high transaction volumes, such as e-commerce or hospitality companies. When the data feeding into retained earnings is consistently reliable, businesses can calculate their figures with more confidence.

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Companies using Ramp can also get real-time visibility into spending to identify opportunities to save and reinvest. For example, a company might notice through Ramp that specific suppliers or subscriptions are eating into profits unnecessarily. Adjusting these expenses helps preserve profits, boosting retained earnings. 

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Ramp’s integration with accounting software ensures these insights flow seamlessly into existing systems, enabling businesses to focus on strategic decisions rather than tedious reconciliations or error correction. Together, accounting software and advanced financial tools create a robust system for managing and optimizing retained earnings.

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