Usually, the calculation of retained earnings is done automatically by accounting software. Virtually any accounting software allows such results to be obtained. However, it is useful to understand how it works and the manual calculation for certain applications.
The advancement of the technical approach of accounting software means that many operations can now be performed mechanically. These are operations that, in the past, were carried out manually.
When we generate the company balance sheet in an automatic accounting program, other financial statements, including the report of retained earnings, are created simultaneously.
However, it is interesting to know how it works, its formula, and how useful it can be to calculate retained earnings manually.
How are retained earnings calculated?
The first step in calculating retained earnings is to know three variables that must apply to the calculation formula.
These variables are as follows:
Retained earnings (current or initial)
It is necessary to know the current or initial retained earnings. That would be equivalent to the retained earnings balances in the last calculation performed. For example, the previous quarter’s retained earnings are used if quarterly balance sheets are made.
Net profit and net loss
These results are also obtained from the accounting period being represented. Continuing with the quarterly balance sheet example, the net profit is the net loss for that quarter.
Dividends
It would be necessary to calculate and apply the different dividends that have been distributed in the period under analysis. Dividends are the profits earned by the company and distributed to shareholders.
The higher the level of share ownership, the higher the shareholdings and the higher the dividend amount. The dividend is directly related to each share: one share equals a certain amount of money per dividend.
What is the formula for calculating retained earnings?
The formula for calculating retained earnings is based on the previous paragraphs’ three variables we have reviewed.
The calculation would be done as follows:
Add the current retained earnings to the profit or loss and subtract the dividend. That is:
- Current retained earnings + Profit or Loss – Dividend.
However, it should note that the effect of dividends will not always be the same as it will depend on how they are issued.
Sometimes companies offer non-cash dividends, i.e., they are not paid in cash. These dividends are rewarded with shares rather than money.
On the other hand, calculating the retained earnings after a stock dividend distribution is not as quick or easy a task as paying in cash.
First, it is necessary to calculate the market value of the shares. On the other hand, it is also essential to know the exact percentage of shares issued as a dividend. That is usually not a large amount.
In this situation, It would modify the formula by adding to the current retained earnings the net profit or loss minus the number of shares delivered in the dividend multiplied by their market value per share.
Other factors to assess
There are obviously other factors to value, although they do not always remain equally necessary or decisive.
A common mistake is to confuse working capital or stockholders’ equity with retained earnings. Although it is also directly related to the balance sheet, they are different concepts.
Shareholders’ equity measures the company’s value in the event of the total liquidation of all its assets.
On the other hand, working capital is a metric used for financing day-to-day operations. This metric is obtained by subtracting all current liabilities from current assets.