Retained earnings represent the cumulative net income that a company has earned and reinvested back into its operations after considering dividend payments. This financial metric plays a crucial role in evaluating the growth potential, financial health, and stability of a business. To accurately calculate retained earnings, it is essential to understand the concepts of assets and liabilities. In this article, we will walk you through the process of calculating retained earnings by analyzing a company’s assets and liabilities.

Understanding Assets, Liabilities, and Retained Earnings:

1. Assets: These are the economic resources a company owns or controls to generate value. They can include tangible assets like property, plant, equipment, inventory, or intangible assets such as intellectual property, patents, or trademarks.

2. Liabilities: These are the obligations and debts a company owes to other parties. Liabilities may include short-term debt such as accounts payable or long-term debt such as bonds payable.

3. Retained Earnings: They reflect the portion of net income that is retained by the company for reinvesting back into operations instead of distributing it as dividends to shareholders.

The Accounting Equation:

The accounting equation helps in understanding the relationship between assets, liabilities, and equity (which comprises retained earnings):

Assets = Liabilities + Equity

Calculating Retained Earnings:

To calculate retained earnings using asset and liability data from your company’s balance sheet, follow these steps:

1. Isolate equity from the accounting equation:

Equity = Assets – Liabilities

2. Find beginning retained earnings from prior period balance sheet:

Retrieve your prior period’s retained earnings from your company’s previous financial statements.

3. Determine net income or loss for the current reporting period:

Incorporate your company’s revenue and expense data to calculate its net income or loss during the current reporting period (usually annually).

4. Calculate dividends paid (if any):

Find out if there were any dividend payments made during the reporting period.

5. Compute ending retained earnings:

Ending Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid

Example:

Let’s keep it simple and consider a hypothetical example:

Company XYZ has assets of $200,000 and liabilities of $80,000. The beginning retained earnings amount to $40,000, while the company’s net income for this period is $60,000 and it has distributed $10,000 in dividends.

Step 1: Equity = Assets – Liabilities

Equity = $200,000 – $80,000 = $120,000

Step 2: Beginning Retained Earnings = $40,000

Step 3: Net Income = $60,000

Step 4: Dividends Paid = $10,000

Step 5: Ending Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid

Ending Retained Earnings = $40,000 + $60,000 – $10,000 = $90,000

Conclusion:

Calculating retained earnings with assets and liabilities data is necessary to evaluate your company’s financial health accurately. It helps you assess the growth and reinvestment capabilities of your business. Understanding the relationships between these financial metrics allows for informed decision-making and better assessment of investment opportunities.