Businesses have two ways that they can utilize their profits. The first is to distribute the money to stockholders in the form of dividends. After all, theoretically, the profits only belong to stockholders. However, companies don’t distribute all of their profits. Instead, they keep some of that on the balance sheet. What are retained earnings and how do you find them on the balance sheet? Also, is there an easy way to calculate retained earnings?
We can divide retained earnings into two portions. The first is the retained earnings in a particular period, which can be a quarter, half-year, or a full fiscal year. This would be the retained earnings for the current period.
What are retained earnings?
Over time, retained earnings in every period keep accumulating on a company’s balance sheet. This would be reflected on the balance sheet as the retained earnings. It's worth noting that while most companies have positive retained earnings, others can have negative retained earnings.
Perennially loss-making companies have negative retained earnings on their books. While a lot of loss-making startup companies will fall in this category, some mature companies also have negative retained earnings, which is a sign that the business isn't doing well.
What do retained earnings tell us?
Retained earnings tell us how much profits the business has held on to the balance sheet over time. In simple terms, it's the company's profits that haven't been distributed to stockholders in the form of dividends but instead retained for future use.
Retained earnings flow from the income statement to the balance sheet and increase (or decrease) the book value per share depending on whether the business had positive or negative retained earnings in that period.
Looking at a recent example of negative retained earnings, let’s dive into AMC Entertainment's balance sheet. The most recent annual report showed a deficit of over $5.3 billion. As a result, the company has a negative book value per share.
How to calculate retained earnings
The formula to calculate retained earnings is straightforward. We simply need to add the retained earnings for the current period to the retained earnings for the beginning period. To calculate the retained earnings for the current period, we would need to subtract any dividends paid from the profit (or loss).
Where to find retained earnings on the balance sheet
Retained earnings can be easily located in a company’s balance sheet. You would just need to come to the stockholder equity section. The most common components of the stockholder equity section in the balance sheet are the issued common stock, the additional paid-in capital, retained earnings, other comprehensive income, and treasury stock.
Looking at Nucor's balance sheet, which is the largest U.S.-based steel company with a good profitability record, it had $11.3 billion as retained earnings on the balance sheet at the end of 2020. For a company with a good profitability record, retained earnings would be a major component of stockholder equity. However, if the company pays out most of the earnings as dividends, the retained earnings would be lower.
Looking at Alphabet’s example, which doesn't pay a dividend, the total retained earnings in the 2020 annual report were almost $135 billion, which was over half of the total liabilities on its balance sheet.
It's worth noting that stockholder equity (which includes retained earnings) is a liability for the company. These funds belong to the stockholders and the company uses them to create assets like plants and equipment.
Retained earnings versus surplus or deficit
Often, retained earnings and surplus are used interchangeably but there's a difference. Surplus is the amount of money invested in the company by stockholders. Chron defines the surplus as “checks shareholders are writing to the organization.” As for the retained earnings, they are the profits left behind after paying dividends.