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September 16, 2021
For startups, retained earnings (RE) isn’t an immediate concern—most newer companies will not pay dividends, as they will need to use funds for growth activities. However, understanding how to calculate retained earnings can be helpful over time. As your equity and liabilities grow, retained earnings will become more important to future growth.
Retained earnings (RE) are funds withheld (or retained) from net income that are not paid to shareholders as dividend payouts. The company’s management determines whether to retain earnings or pay out the money to shareholders.
The basic formula for the retained earnings calculation is:
Retained Earnings = Beginning Period Retained Earnings + Net Income or Loss – Cash Dividends – Stock Dividends
In basic terms, retained earnings are the historical cumulative profits minus dividends paid. For example, if an ecommerce company has a net income of $2 million with no beginning period retained earnings and paid $1 million in the form of cash dividends, the company’s RE is $1 million.
Retained earnings is an important concept for stockholders, creditors, and company management. For investors, retained earnings provides a quick indication of a company’s profitability. It’s an important metric to consider when evaluating mature companies; investors will look at retained earnings over time, evaluating whether the retained earnings generated returns and whether the funds could be paid as dividends in the future.
A single quarter’s RE doesn’t provide much insight, but multi-year trends can help to guide investments. This can be expressed in metrics like retained earnings-to-market value, which gauges the total retained earnings per share against the change in stock value. This tells shareholders whether the company’s retained earnings are generating a return.
Creditors will also consider retained earnings in the context of the company’s overall health. On the balance sheet, retained earnings are a type of equity reported as shareholders' equity. However, for growing businesses, metrics like revenue, executive compensation, and cash flow can have a greater impact on creditor and investor decisions.
Your company’s management will also need to review retained earnings statements regularly when determining how to allocate capital. Over time, your retained earnings can demonstrate whether certain investments paid off, which can be useful when planning new projects.
So, what are retained earnings for a startup? While retained earnings statements aren’t particularly insightful in the short term, your startup will still need to generate them. Fortunately, this is a fairly simple process.
If you’re operating a typical business, the retained earnings formula for your first calculation will be your retained earnings or loss (unless you pay dividends right away). The math remains simple until you pay dividends; at the end of each accounting period, your retained earnings will be your beginning retained earnings, along with the current accounting period’s net income or loss.
Here’s a step-by-step process for establishing your first retained income statement:
The retained earnings ending balance from the prior period will become the retained earnings beginning balance in subsequent periods. Retained earnings can be negative if a company has a net loss that exceeds the retained earnings of the previous accounting cycle. Of course, most growing companies will not pay dividends, and the vast majority of startups have negative income for long periods of time before generating a profit. While negative retained earnings are perfectly acceptable for a new business, effective management of RE can improve a startup’s long-term scalability.
As we’ve discussed, startups are generally expected to accumulate a deficit, and even if a startup is able to generate net income, it’s unlikely to pay dividends. The focus is on scaling their businesses, so retained earnings aren’t a major priority. Put simply, negative retained earnings aren’t a major concern for new companies as they’re likely using that money for operating expenses and reinvestment into the business.
Retained earnings can be used as working capital for:
For most businesses, the company’s management will make the decision to distribute earnings to shareholders or retain it for future use. However, shareholders may contest the decision through a vote. Again, this is rarely a concern for startups—but it’s important to remember that long-term shareholders expect a return on their investment.
All audited financial statements will require a statement of retained earnings. Public companies must disclose their retained earnings, and private businesses need RE statements (along with balance sheets, income statements, and other statements) to apply for funding.
In the long term, a consistently negative retained earnings account can be an indicator of significant financial solvency issues and poor company equity—but company management typically makes the decision to retain earnings, and new businesses need to invest in high-return projects. These capital allocations are essential for growth and expansion.
With that said, retained earnings is important in the long term, even for startups: Over time, RE indicates a business’s health. For the first few years of reporting, a business will likely post negative retained earnings, but investors may consider whether the RE is decreasing or increasing. While the retained earnings balance should always be considered in context, it can help to establish whether a company’s management has a history of making appropriate investments.
As with all aspects of accounting, accuracy is important when calculating a retained earnings statement—and as startups grow, those calculations can become more complex. This is true regardless of your accounting methods; if you maintain a manual ledger, the retained earnings statement will be inaccurate if your accounting team doesn’t generate closing entries prior to the calculation.
And while accounting software can generate RE statements automatically, these statements can be inaccurate if you use a variety of software tools to handle your finances and accounting. For instance, many organizations have a fragmented accounting and finance framework that uses separate tools for common functions like bookkeeping, payroll, annual taxes, and financial projections.
When a business has a small team of employees, this fragmentation may not seem like a significant problem. As your business grows and begins issuing positive retained earnings statements, the fragmentation can become a much bigger issue.
Your startup probably won’t spend much time obsessing over retained earnings statements, and as we’ve discussed, negative retained earnings are common for new businesses. However, effective financial management will inevitably determine the success of your growth strategy.
Zeni’s full-service financial resources allow startups to establish the best practices that facilitate long-term growth. By building systems that handle daily bookkeeping, CFO services, bill payments and invoicing, employee reimbursements, and annual taxes, our team limits the time you spend on financial management. Real-time reporting gives you the information you need to compare your spending from month to month, so when you’re ready to begin offering dividends, you’ll have the tools to make strong capital allocations from your retained earnings.
Zeni combines human expertise with artificial intelligence and machine learning to limit the time you spend on financial tasks. Our experienced tax professionals understand that no two startups are the same, and we’ll help you find solutions tailored to your unique needs.