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Financial statements are not only helpful when it’s time to file your small business taxes, but they also shed a light on your business’s finances. There are three key financial statements every business owner should understand: the profit and loss statement (also known as the P&L or income statement), the balance sheet, and the cash flow statement. Each of these key financial statements tells a different part of your business’s money story. Together, they form a complete narrative, which you can use to make informed business decisions grounded in hard data instead of based on gut instinct.
But there is a fourth financial statement that can give you even more clarity about your business’s financial story. You might consider this financial statement the epilogue to the story. That statement is called the statement of retained earnings.
In this guide, we’ll define retained earnings and explain what a statement of retained earnings is, as well as its purpose and how to prepare a statement of retained earnings.
In order to understand the statement of retained earnings, you must first understand retained earnings. In short, retained earnings are the profits your business has earned and kept in the business.
Let’s illustrate with an example:
Suppose your business shows a net profit on the P&L of $50,000 for your first year of business. Of that $50,000, you owe $15,000 in dividends to your shareholders (this can include you).
$50,000 net profit – $15,000 dividends = $35,000
The remaining $35,000 in this equation is your business’s retained earnings.
In your second year of business, let’s say your net profit jumps to $150,000 (congratulations!). You owe $50,000 in dividends to your shareholders. But now we have to include your retained earnings from year one in the calculation:
$35,000 year 1 retained earnings + $150,000 year 2 net profit – $50,000 dividends = $135,000
Your retained earnings are now $135,000.
It’s important to understand that the retained earnings number is not the same as cash retained in your business. In order to track the flow of cash through your business—and to see if it increased or decreased over a given period of time—you will need to review your statement of cash flows.
Retained earnings tell the story of what your business has done with its profit (which, again, is not the same as cash). This profit can be reinvested in the business by purchasing new assets. It can also be used to pay down liabilities.
Retained earnings are reported in the equity section of your balance sheet. According to the balance sheet equation (Assets = Liabilities + Equity), equity is what remains after all your creditors are paid from your business’s available assets.
Equity can be further broken down into a number of different subcategories:
And, as we’re about to learn, retained earnings can be broken down into a statement of retained earnings. But, before we get to that, you might be wondering:
The answer to this question is a resounding: “Sort of.”
In a sole proprietorship, all equity belongs to the business owner. What happens to this equity is the sole decision of the business owner: There are no shareholders who are due dividends, and the business owner doesn’t have to explain to anyone what he or she does with the business’s profits.
Technically, according to accounting theory, sole proprietorships don’t have retained earnings. Sole proprietorships only have owner’s equity, and retained earnings apply only to corporations. However, your accounting software will most likely show profits left in your sole proprietorship year over year as retained earnings. And we don’t see any harm in treating your sole proprietorship like a corporation when it comes to analyzing what happens to the profits in your business.
So, it can be argued that you don’t have retained earnings if your business is a sole proprietorship, but–in practice–you will have retained earnings.
The statement of retained earnings is a detailed financial statement that shows changes in retained earnings from the beginning of a financial period to the end of that same financial period. This financial period is typically one year.
The statement of retained earnings can also be called a statement of shareholders’ equity. If your business is a sole proprietorship, your statement of retained earnings might be called something different, like statement of owner’s equity, or equity statement. Regardless of what it’s called, the statement of retained earnings follows the same basic equation:
Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
In a small business situation, the dividends will most likely be distributed immediately, and they are usually only distributed to one or two people. In larger companies, this isn’t always the case. Regardless of when the dividends are actually paid, they are deducted from retained earnings in the statement of retained earnings.
You might be wondering why your bookkeeper or accountant hasn’t prepared a statement of retained earnings for your business and reviewed it with you. In small businesses, the statement of retained earnings can serve to give you clarity on how your business has accumulated and used its profit over time. However, this statement isn’t critical for business operations, and so it isn’t often produced for small businesses.
The statement of retained earnings does come in handy when your financial statements are prepared for outside entities, like investors and lenders.
Investors—both current and potential—like to see how a company uses its profits. They want to know the company is using their investment dollars wisely and that they will ultimately see a return on that investment. A business that reinvests a portion of its profits into helping the business grow—while still paying out dividends—will remain attractive to existing investors and could help attract new ones.
Lenders, on the other hand, use your historical financial statements to predict how you’re likely to run your business in the future. A statement of retained earnings that shows you are retaining profits in your business rather than distributing them all will improve your lenders’ confidence in your business’s ability to repay its obligations.
A statement of retained earnings can range from extremely simple to very detailed. To illustrate, here are some statement of retained earnings examples. In its simplest form, using the example above starting in year 2, your statement of retained earnings would look something like this:
XX = Previous Year, XY = Current Year
But there can be a lot more than net profit in your retained earnings number. If you pay capital into your business and don’t take it back out again, that impacts your equity in the business.
Let’s say you invest $100,000 in your business in year 3. This is an investment–not a loan you intend to repay yourself–and so it gets added to your equity in the business.
Your net profit for year 3 is $175,000 and you owe $75,000 in dividends to your shareholders.
In this case, you’ll want to expand your statement of retained earnings to reflect the paid-in capital. Your new statement of retained earnings would look like this:
This shows exactly how your contributed capital in the business impacts the total equity in the business. If you issue stock in the business, the changes in that stock would also appear in the expanded statement of retained earnings.
The statement of retained earnings serves as a sort of epilogue to your business’s financial story. It breaks down the retained earnings number in the equity section of your balance sheet, so you—or your investors or lenders—can see how your business is using the profits it generates.
The statement of retained earnings can be useful to all businesses, even sole proprietorships. Even though all retained earnings are technically owner’s equity in a sole proprietorship, seeing how you are using that equity in your sole proprietorship can provide you valuable insight into how you are managing the profits of your growing business… and how you can do things better.
Chances are, your accountant or bookkeeper won’t prepare this statement for you unless you specifically ask for it. This is because the statement of retained earnings isn’t relevant to business operations. It is a valuable statement to have as you assess the growth of your company, though. Discuss with your accountant or bookkeeper how they can help you use the information in the statement of retained earnings to help you fully comprehend your business’s money story.