Understanding retained earnings vs net income is important for a business to get an accurate picture of its finances. In this post, we’ll go over some commonly confused accounts and calculations. We’ll also talk about how they work together for financial decision-making and business growth.
What is Retained Earnings?
Retained earnings are the cumulative net earnings or profits of a company after subtracting dividend payments. It represents the portion that the business retains for future use.
Retained earnings add up over time as long as the company continues to generate profits and retain a portion of them. This accumulated wealth can be used not only to fund future growth, but to invest or reduce debt.
Retained Earnings and Equity
Retained earnings are a subset of shareholder’s equity, as the portion of accumulated profits that the business chooses to reinvest. As a business sees an increase in retained earnings, it can strengthen its financial position.
Calculating Retained Earnings
Retained Earnings = Beginning Retained Earnings + Net Income – Dividends
Recording Retained Earnings
Retained earnings are usually located towards the bottom of the shareholder’s equity section of the balance sheet. You would list it as a separate line item, typically below the contributed capital section.
What is Net Income?
Net income is a business’s profit after subtracting all its expenses, including taxes, from the total revenue. This is why it’s often called the “bottom line” of the income statement.
The formula is: Net Income = Revenue – Expenses
Measuring Profitability
Profitability Ratios
- The Net Profit Margin measures the percentage of net income relative to total revenue. The higher, the more profitable the business is.
- Return on Equity measures how efficiently a business uses its shareholders’ equity to generate profits. The higher, the more profitable the business uses shareholder funds.
- Return on Assets measures how efficiently a business uses its assets to generate profits. The higher, the better the business uses its assets.
Dividend Policy
Many businesses give higher dividend payouts when net income is higher.
Investment Decisions
Investors often use net income to evaluate the business’s financial health and investment potential. So, a consistent increase in net income can mean a strong, growing company.
Creditworthiness
Profitability shows lenders and creditors that a business is creditworthy. Higher net income can boost a business’s credit rating.
Recording Net Income
Net Income and Business Health
Say a certain business invests heavily in research and development, marketing, and hiring top talent for an innovative product. As a result, It incurs significant expenses in its early years, which leads to negative net income. In other words, the business’s revenue is not yet sufficient to cover all its expenses.
After a few years, the product gains traction in the market, boosting revenue substantially over the next few years. The business also becomes more efficient in its operations at the same time. This creates positive net income as the business’s revenue exceeds its expenses, and results in a profit.
Key Differences Between Retained Earnings and Net Income
Time Frame
Single Period’s Profit, or Net Income, is the profit or loss that a business generates over a specific accounting period. It’s a quick view of financial performance, calculated thus:
Revenue – Expenses = Net Income
Accumulated Earnings, or Retained Earnings, is the cumulative net income of a business over its entire lifespan, after deducting any dividends. It’s a long-term view of overall financial health and the business’s ability to reinvest in itself. The formula is:
Beginning Retained Earnings + Net Income – Dividends Paid = Ending Retained Earnings
A single period’s profit contributes to the overall accumulated earnings. Retaining or distributing profits impacts the accumulation.
Location
The Balance Sheet is typically presented first among all the financial statements. The Income Statement usually comes next. Often the two are presented side by side on a page.
Impact on Internal Decision-Making
Investment Decisions
More retained earnings creates a strong internal source of funding. Consistent positive net income shows a healthy financial position, so the business can invest in future growth opportunities.
Dividend Policy
A healthy retained earnings balance allows the business to pay dividends while maintaining financially stable. Higher net income generally supports a more generous dividend policy, which can attract and retain investors.
Debt Management
A high level of retained earnings can reduce the amount of external financing needed, which lowers debt and interest costs. Steadily positive net income improves the business’s creditworthiness, so that it can secure loans at favorable interest rates.
Impact on External Decision-Making
A higher retained earnings balance means that a business can reinvest in itself and generate future growth. Steady positive net income is a sign of profitability and financial stability. This makes the business an attractive opportunity for investors.
Healthy retained earnings indicates a stronger financial position, which reduces the credit risk for lenders. As positive net income improves creditworthiness, the business can more easily secure loans and other forms of financing.
Measurement
Basically, retained earnings show a long-term perspective on a business’s financial strength and its ability to reinvest in itself. Net income gives just a snapshot of its current financial performance.
How Retained Earnings and Net Income Work Together
It all starts with net income as the direct source of retained earnings. Retained Earnings is the portion of the net income that a business keeps for future use. However, the amount of dividends that a business pays out reduces the amount of net income that is available for retention.
Example Over Multiple Periods
Retained Earnings and Net Income in Financial Decision-Making
Operations
Consistent positive net income gives a business the financial foundation for sound short-term operational decisions. The businesses can then allocate resources effectively, manage risks, and seize opportunities to drive growth and profitability.
It covers areas like daily operations, investment in growth, contingency funds, optimal purchasing, competitive pricing strategies, marketing and promotional efforts, top talent acquisition, employee incentive programs, and risk management.
Financial Health
Analyzing both retained earnings and net income can show investors, creditors, and management important insights. They can assess financial health, growth potential, and risk profile. A strong track record of profitability and a healthy level of retained earnings presents a company as a more attractive investment with a lower credit risk.
The Role of Retained Earnings in Business Growth
Reinvestment
Businesses typically strategically reinvest retained earnings to:
- Expand operations by opening new locations and increasing production capacity.
- Marketing and advertising to increase brand awareness, attract new customers, and expand their customer base.
- Acquire competitors and collaborate with other companies to access new markets or technologies.
Funding
Businesses can use retained earnings to pay for:
- More research and development for new products, adapting new technologies, and streamlining operations.
- Debt obligations to lower interest expenses and improve financial flexibility.
Dividends vs. Retained Earnings
Young, high-growth companies can choose to prioritize reinvestment/. More mature companies often opt to focus on dividends. Strong financial health allows for both dividends and reinvestment.
Note that shareholders may prefer dividends or capital appreciation. Dividends also attract new investors and can increase the stock price. However, reinvesting profits means more fuel for growth and less reliance on external financing to improve financial stability.
The Impact of Net Income on Taxes
Direct Impact
A higher net income generally means a higher tax liability. However, tax professionals can identify deductions credits to mitigate the impact as well as suggest other tax planning strategies.
Calculating Taxes
Net income is the figure you start with when calculating taxable income. From there, you apply different adjustments, deductions, and credits to get the taxable income. Aside from the ones mentioned above, common adjustments include business expenses, interest expense, and depreciation and amortization.
Based on your taxable income, you would apply the appropriate tax rate and calculate the tax liability.
Common Misconceptions About Retained Earnings and Net Income
Available Cash
Retained earnings represent the cumulative net income of a business over time. This does not directly equate to cash available for spending, however. It shows financial strength and ability to reinvest. A better measure of cash on hand is the cash flow statement.
Operating Cash Flow
Net Income recognizes revenue and expenses even when cash is not yet exchanged. Operating Cash Flow focuses on actual cash inflows and outflows. So, the business can have a positive net income, but negative operating cash flow.
Net income can’t tell you if the business has potential liquidity issues. Operating cash flow will be how you see whether the business can fund investments, pay dividends, or reduce debt.
Negative Net Income
Retained earnings cannot grow when there is negative net income because it reduces the retained earnings balance. This is true even if no dividends are paid.
Frequently Asked Questions
Can a company have positive retained earnings but negative net income?
Because retained earnings is a cumulative calculation, you can have negative net income for a period and still see positive retained earnings.
How often should a business review its retained earnings and net income?
There’s no clear answer to how frequently a business should review retained earnings and net income. Basically, regular reviews help a business make informed decisions, identify potential risks, and capitalize on opportunities to drive growth and profitability.
Do retained earnings need to be reinvested in the business?
A business does not have to reinvest retained earnings in itself. Retained earnings can go towards dividend payouts, debt reduction, and building a cash reserve for unforeseen hurdles and opportunities.
How can a company improve both net income and retained earnings?
Basically, improving both net income and retained earnings means increasing revenue, reducing costs, improving efficiency, making strategic investments, and implementing sound financial management.
How do retained earnings affect a company’s valuation?
Higher retained earnings shows an ability to weather economic downturns and fund future growth. This is attractive to investors. Successful investments can lead to increased revenue, profits, and ultimately, a higher valuation.
Retained earnings can also support dividend payments, which can also increase investor interest and potentially boost the stock price.
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In Summary
Understanding retained earnings vs net income can help a business plan for improved financial health and stability. By deciding a healthy balance for retained earnings and managing these funds properly, a business can also ensure stable growth and weather unforeseen storms.
