When you’re looking for funding or trying to attract investors, you may find yourself in need of a retained earnings statement. If they like what they see, you’ll need to be able to explain how you came up with the numbers in your statement. Savvy business owners don’t rely solely on their accountants for information. They understand the factors that go into their financial reporting.
What are retained earnings?
As with many things in accounting, the answer to this question is in the name. Retained earnings are profits that are left over after dividends have been paid out to shareholders. The retained earnings statement is also known as the statement of shareholder’s equity because it’s used to determine the value of each share of stock issued by the company.
Calculating retained earnings should be simple if you know how to create a balance sheet, but retained earnings sometimes get confused with net income and revenue. They are not the same. The “shareholder’s equity” entry on your balance sheet is the line item you need for retained earnings. We’ll get into the math below.
Retained earnings vs net income
There are several good reasons why financial reporting is done with multiple documents. Net income is found on the income statement. It’s calculated by adding up sales revenues and deducting cost of goods sold (COGS), operating and administrative expenses, depreciation and amortization, financial income or losses, and taxes. These are all useful FP&A data points.
Net income is the net profit margin after covering short-term liabilities, but it doesn’t account for long-term liabilities or dividend payments. Retained earnings, because they are calculated using the shareholder’s equity number from your balance sheet, account for both. You’ll use net income in the formula to calculate it, but the numbers are not the same.
Retained earnings vs revenue
Revenue is also a line item on the cashflow statement. Net revenue comes immediately after sales and cost of goods sold, so it also has nothing to do with retained earnings. Assuming that high net revenue translates into high retained earnings is a mistake. Only the net income number on the income statement is relevant to shareholder equity.
The revenue number is important if you’re wondering how to measure your company’s financial performance, but it’s only one data point. Retained earnings tell shareholders how much their shares are worth. Other metrics, like EBITDA and net revenue, show how efficiently the company is operating. It’s important to look at all these when evaluating a business.
What is a retained earnings statement?
A retained earnings statement is an official financial report that states what the retained earnings for a specific period are. They’re used to set the stock price and to calculate an equity multiplier if you want to sell or merge your company, so accuracy is critical. A typical retained earnings statement contains the following line items:
· Retained earnings from last period: From “shareholder’s equity” line of your balance sheet
· Prior-period adjustments: If needed, any mathematical corrections can be placed here
· Adjusted retained earnings from last period: only if needed
· Net income for the reporting period
· Net total prior to dividends
· Dividend payments
· Retained earnings for the current period
With no adjustments from the previous period, this could easily be a four-line report. The formula is simple. Take the shareholder’s equity number from the last balance sheet (REO), add it to the net income number from the current income statement (NI), and subtract dividends (D), which are on this year’s balance sheet. The formula looks like this:
What other financial statements do small businesses need?
To compile any of these, you’ll need an efficient accounting department that’s keeping a general ledger of debit and credit transactions. Those entries are the building blocks, the “brick and mortar” of financial reporting. They can be used to create the reports that tell your company’s story to owners, investors, and shareholders. These reports include:
The balance sheet is the first of five “official” financial reports recognized and governed by the Financial Accounting Standards Board (FASB). It’s a comprehensive look at a company’s assets, liabilities, and shareholder equity adapted from a double entry general ledger. Balance sheets are a key element in business financial analysis.
The income statement is a report of the company’s revenues, expenses, gains, and losses. It’s often used to calculate business ratios that measure the profitability and solvency of a company. Data points that can be found on the income statement include EBITDA, operating income, gross profit, and net income.
Comprehensive income statement
The comprehensive income statement is only required if the business is doing currency translations, hedging, or pensions. This statement begins with net income from the standard income statement and adds in any income that doesn’t fit into traditional categories.
Statement of cash flows
This statement breaks down cashflows into operating, investing, and financing activities. It’s useful for seeing where money is being spent and whether changes can be made to make a company more efficient.
The P&L statement shows a company’s profits and losses for the reporting period. It can be useful for breaking expenses down into categories to make tax filings easier. The P&L is not part of the official financial reporting recognized by the FASB, but it is a useful internal document to keep track of expenses.
Next steps after creating a retained earnings statement
Calculating retained earnings provides clarity on funds availability after all business obligations have been met. It’s money that can be saved and applied to shareholder’s equity for the next reporting period, or it can be reinvested to grow the business. This is a decision that should be made with your board of directors if you have shareholders.
Ramp can assist you with this by ensuring your expense records from the previous reporting period are accurate. Our direct integrations with popular accounting softwares can help you comply with GAAP regulations like expense recognition and accrual accounting procedures.
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