What is Retained Earnings?
The cumulative profits a business has earned and kept rather than distributed to owners or shareholders as dividends or withdrawals.
Definition
Retained earnings (also called "retained profits" or "accumulated earnings") is the portion of a company's net income that is retained in the business rather than paid out to owners, shareholders, or partners as dividends or distributions. It is calculated cumulatively over the life of the business and appears as a component of stockholders' equity on the balance sheet. Retained earnings represent the total value that the business has generated and reinvested in itself since inception. For a sole proprietorship or LLC, owner withdrawals reduce retained earnings; for a corporation, dividend payments reduce retained earnings.
The Retained Earnings Formula
Retained Earnings (Current Period) = Beginning Retained Earnings + Net Income for the Period - Dividends/Owner Distributions Paid. This is sometimes called the "retention ratio" or " plowback ratio." For example: A freelance design studio starts the year with $20,000 in retained earnings. During the year, it earns $80,000 in net profit after all expenses. The owner withdraws $30,000 for personal use. Ending retained earnings = $20,000 + $80,000 - $30,000 = $70,000. Note that owner distributions are not expenses — they are simply reductions in the equity of the business.
Retained Earnings vs. Revenue
Revenue is the income earned from providing services or selling products during a specific period — it is the "top line" of the income statement. Retained earnings is the cumulative total of net income that has been kept in the business over time, minus any distributions. A business can generate significant revenue in a year but have low or negative retained earnings if it distributes more than it earned. Conversely, a profitable business that has never distributed earnings will have high retained earnings relative to its revenue. Understanding both metrics gives a complete picture of financial performance and shareholder return strategy.
What Businesses Do with Retained Earnings
Companies use retained earnings in several ways: Reinvest in the Business — purchase new equipment, hire staff, or expand facilities; Pay Down Debt — reduce liabilities to strengthen the balance sheet; Build a Cash Reserve — accumulate liquid assets for future opportunities or downturns; Acquire Other Companies — finance acquisitions or investments; Issue Stock Dividends — distribute additional shares to shareholders (rather than cash); or simply Hold Them — some companies deliberately retain earnings to maintain financial flexibility. The decision of whether to retain or distribute earnings is a key strategic and financial planning decision.
Retained Earnings on the Balance Sheet
Retained earnings appears in the equity section of the balance sheet, alongside common stock and additional paid-in capital. The basic accounting equation is: Assets = Liabilities + Stockholders' Equity (or for non-corporate businesses: Assets = Liabilities + Owner's Equity). A statement of retained earnings is often prepared as a separate financial statement showing the beginning balance, net income, dividends, and ending balance. Negative retained earnings (a deficit) appear when a company has accumulated losses that exceed its retained earnings, which can be a red flag for financial health.