The Number Hiding in Plain Sight
Most small business owners check two numbers first: how much money is in the bank and how much profit they made this month. Both matter, but another number on your balance sheet can reveal more about your business’s financial history.
That number is retained earnings.
Retained earnings represent the accumulated profits a corporation has kept over time after accounting for dividends and certain adjustments. They can help you understand how your business has performed financially and how much of its earnings have remained in the company rather than being distributed to shareholders.
Understanding retained earnings can help you make more informed decisions about growth, spending, and your business’s financial future.
What Are Retained Earnings?
Retained earnings are the accumulated profits a corporation has earned over time, minus dividends and certain adjustments.
When a company earns a profit, retained earnings generally increase. When it experiences a loss or pays dividends, retained earnings generally decrease.
You can find retained earnings in the equity section of a corporation’s balance sheet, alongside other equity accounts.
One important point: retained earnings are not the same as cash.
A business could report $200,000 in retained earnings but have only $15,000 in its bank account. Its profits may have been used to purchase equipment, vehicles, or inventory, pay down debt, or cover other business expenses.
Retained earnings reflect accumulated accounting results, not the amount of cash currently available to spend.
The Retained Earnings Formula
The basic formula for a corporation is:
Beginning Retained Earnings + Net Income − Dividends = Ending Retained Earnings
If the company has a net loss instead of net income, subtract the loss from beginning retained earnings. Certain prior-period adjustments may also affect the ending balance.
A Quick Example
Imagine a Florida pool supply corporation starts the year with $80,000 in retained earnings.
During the year:
- The company earns $45,000 in net income.
- The company pays $15,000 in dividends.
Here is the calculation:
$80,000 + $45,000 − $15,000 = $110,000
The company ends the year with $110,000 in retained earnings, an increase of $30,000.
This means the company’s retained earnings balance grew during the year. It does not necessarily mean the company has $30,000 in additional cash because its money may have been used for other business purposes.
Where Do Retained Earnings Come From?
Retained earnings can change for several reasons.
1. Net income or net loss
Profits generally increase retained earnings, while losses decrease them.
2. Dividends
When a corporation distributes dividends to shareholders, the distribution generally reduces retained earnings.
3. Prior-period adjustments
Corrections to certain accounting errors from previous periods may affect beginning retained earnings. The appropriate treatment depends on the nature of the error and the applicable accounting rules.
This is one reason accurate bookkeeping matters. Errors in previous periods can affect financial statements and make it harder to understand how your business has performed.
Does Every Business Have Retained Earnings?
Not every business uses a separate retained earnings account in the same way. The accounting presentation depends on the business structure and how it is taxed.
- C corporations: Generally report retained earnings as part of shareholders’ equity.
- S corporations: May report retained earnings in their financial statements, but shareholder tax basis, distributions, and other tax accounts follow separate rules.
- Sole proprietorships: Generally track the owner’s equity through a capital account rather than a separate retained earnings account.
- LLCs and partnerships: Commonly track members’ or partners’ equity through capital accounts. Their accounting presentation depends on their structure and applicable reporting practices.
The important distinction is that accounting profit, cash available to the owner, and taxable income are not necessarily the same amount.
If you are unsure how your business should record profits and withdrawals, ask your bookkeeper or tax professional to review your accounts.
What Retained Earnings Reveal About Your Business
Retained earnings become more useful when you review them alongside other financial information and compare results over several years.
1. Long-Term Profitability
A growing retained earnings balance may indicate that a corporation has generated profits over time and retained some of them.
However, a growing balance does not automatically mean the business is financially healthy. Review it alongside revenue, expenses, debt, cash flow, and other financial statements to understand the full picture.
2. How You Use Your Profits
Retained earnings can help you understand how much profit has remained in the corporation rather than being distributed as dividends.
Consider two landscaping businesses. One distributes most of its profits to shareholders, while the other retains more earnings to help fund equipment purchases and future expansion.
The second business may have more resources available for planned investments, but its actual ability to pay for those investments still depends on cash flow and other financial obligations.
Neither approach is automatically better. The right decision depends on the company’s needs, financial position, and growth plans.
3. Potential Warning Signs
A negative retained earnings balance is known as an accumulated deficit.
It generally means accumulated losses and other adjustments have exceeded accumulated profits and dividends over time.
A negative balance does not automatically mean the business is failing. A new business may experience losses during its early years, for example.
However, if the deficit continues to grow, it is worth reviewing pricing, operating expenses, revenue, and financial obligations to identify potential problems.
4. Readiness for Growth
Retained earnings can help business owners and lenders understand a company’s financial history.
A corporation that consistently earns profits and retains some of them may be better positioned to fund certain growth opportunities. However, lenders may also examine cash flow, existing debt, credit history, profitability, and other financial statements.
A strong retained earnings balance alone does not guarantee loan approval or prove that a business can afford an expansion.
5. Whether Distributions Are Sustainable
If a corporation regularly distributes dividends, it is worth reviewing whether those payments fit its financial position and future plans.
For other business structures, owner withdrawals or member distributions are generally tracked through the appropriate equity accounts rather than treated automatically as dividends.
Reviewing distributions alongside cash flow, outstanding obligations, and expected expenses can help owners make more informed decisions about how much money to take out of the business.
A Tax Note for C Corporations
C corporations should understand the federal accumulated earnings tax.
The IRS may impose a 20% tax on accumulated taxable income when a corporation retains earnings beyond the reasonable needs of the business under circumstances covered by the accumulated earnings tax rules.
The IRS generally treats accumulated earnings and profits of $250,000 or less as within the reasonable needs of most businesses. A $150,000 threshold applies to certain corporations whose principal function is performing services in specified fields, including accounting, law, health, engineering, and consulting.
These amounts are not blanket tax-free allowances, and exceeding them does not automatically mean the corporation owes this tax. The corporation’s circumstances, purpose for retaining earnings, and documented business plans matter.
For example, a corporation may retain earnings to fund a specific expansion or purchase necessary equipment. It should maintain appropriate documentation supporting its business plans and financial decisions.
If your corporation is accumulating substantial earnings, consult a qualified tax professional to determine how the rules apply to your situation.
Source: IRS Publication 542, Corporations.
Practical Tips for Small Business Owners
Here are several ways to make better use of your financial statements.
- Review your financial statements regularly. Compare retained earnings from one period to the next and investigate significant changes.
- Compare retained earnings with cash. A high retained earnings balance does not guarantee that cash is available to cover expenses.
- Plan distributions carefully. Consider upcoming expenses, debt payments, taxes, and investment needs before deciding how much money to distribute.
- Keep your books current. Accurate records help ensure your financial statements reflect business activity correctly.
- Look at the trend over time. One loss or a temporary decline does not tell the whole story. Review multiple periods alongside other financial measures.
- Ask questions when something looks unusual. Your bookkeeper can help explain changes in your accounts and identify transactions that may need review.
Common Questions About Retained Earnings
Are retained earnings an asset?
No. Retained earnings are part of equity, not an asset. Assets such as cash, inventory, and equipment are reported separately on the balance sheet.
Can I spend retained earnings?
Retained earnings are an accounting balance, not a separate pool of cash. A business spends available cash or other resources. If retained earnings are high but cash is low, the company may have invested its resources elsewhere or used them to meet financial obligations.
Is a high retained earnings balance always good?
Not necessarily. A high balance can reflect accumulated profits, but it does not tell you everything about the company’s liquidity, debt, or profitability. C corporations should also consider whether the accumulated earnings tax rules apply to their circumstances.
Are retained earnings the same as taxable income?
No. Retained earnings are an accounting measure of accumulated profits after applicable distributions and adjustments. Taxable income is calculated under tax rules and may differ from accounting income.
Conclusion
Retained earnings may sit quietly on a balance sheet, but they can tell you an important part of your business’s financial story.
They help show how profits and losses have accumulated over time and how much of those profits have remained in a corporation. However, they should always be considered alongside cash flow, debt, profitability, and other financial information.
Review your financial statements regularly, keep your books accurate, and make informed decisions about distributions and future investments.
How Accredited Bookkeeping Can Support Your Business
At Accredited Bookkeeping, we understand the challenges small businesses face when it comes to managing finances. We’re here to help you streamline your bookkeeping processes, avoid unnecessary financial errors, and gain greater clarity about your financial health. Our services are designed to fit the specific needs of your business, giving you peace of mind while you focus on growth.
Contact us today for a free consultation and discover how we can make bookkeeping easier for you.
marianne@accreditedbookkeeping.com
Marianne Kirwan
352-626-0116
