What is a statement of retained earnings and who needs one?
As a small business owner, you’re focused on providing a great product or service and building something from the ground up. What you didn’t sign up for was all the financial statements you need to keep. While you may be more familiar with a cash flow or income statement (aka profit and loss), there’s another important document that could be useful to you: a statement of retained earnings.
A retained earnings statement is quite useful if you’re applying for a loan or investment funding. Why? It gives investors or lenders a good idea of how healthy the business is.
Related: Save money with these small business accounting tricks
How to create your own statement of retained earnings
Creating a statement of retained earnings is a simple five-step process.
- Start with a heading.
- State previous years’ retained earnings.
- Add your net income for the reporting period.
- Subtract dividends.
- Record the total retained earnings.
Let’s define retained earnings before we explain step by step how to create this statement for your small business.
What are retained earnings?
Retained earnings are the profits a business keeps in the business after paying out dividends.
For example, let’s say your income statement shows a net profit of $100,000 in year one. The business owes $30,000 in dividends to stockholders (which can include you), leaving $70,000 in retained earnings.
In year two, let’s imagine you earn the same profit and owe the same dividends. Your retained earnings would now be $140,000. Your retained earnings at the end of the reporting period include those at the beginning of the year. You can use this simple formula:
Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
For year two in our example, that formula would look like this:
$70,000 + $100,000 – $30,000 = $140,000
It’s important to remember that retained earnings are not the same as cash in hand. Retained earnings are used to pay off debt obligations, make capital investments or they can be kept as cash.
Does a small business need a retained earnings statement?
Retained earnings for a small business appear as equity, whereas a corporation would always show them. If you’re a sole proprietor, your accountant may have never created a statement of retained earnings for your business, because technically it is all equity that you own.
Investors and lenders will look at your statement of retained earnings to see what you do with profits. Investors want to know you pay a healthy return. Lenders want to see reserved profits that can be used to pay off debt or expand operations.
How to prepare your statement of retained earnings
Preparing a statement of retained earnings is simple, and something you can do on your own. Follow these steps:
1. Start with a heading
There should be a 3-line header that identifies the document and looks like this:
Statement of Retained Earnings
For the Year Ended XXXX
“Year” can also be substituted by the appropriate reporting period, such as month or quarter.
2. State previous years’ retained earnings
The first item should be your result from the previous year. If this is your first time making this document, you can use last year’s balance sheet to find what was left of your net earnings after paying dividends.
3. Add your net income for the reporting period
Use your income statement for this number.
4. Subtract dividends
This includes dividends paid to any shareholders, including yourself. In a sole proprietorship, those dividends are paid immediately, but regardless when shareholders are paid, they are deducted in this statement.
5. Record the total retained earnings
Finally, calculate the total ending retained earnings.
If you’re looking for a visual template, you can use one of these as the basis for your own.
What if your retained earnings are negative?
In addition to its usefulness in attracting funding, a statement of retained earnings can be a good way to judge if your business is in trouble. You may be drawing down reserved profit from better years, and this statement can reveal if your business is being kept afloat by those dwindling reserves.
In this case, you may want to look into insolvency options such as a Division 1 Corporate Proposal or bankruptcy. A Division 1 Corporate Proposal is designed for businesses that owe unsecured debt and individuals owing more than $250,000. It is not restricted exclusively to corporations.
The goal of a Division 1 is to keep your business out of bankruptcy.
If you are a sole proprietor and your total debts are less than $250,000, you may want to consider a Consumer Proposal or bankruptcy to get out of debt.
By preparing and reviewing a statement of retained earnings, you can improve your understanding of your business’s performance. It can help you see whether you’re reinvesting in the business or relying on savings or capital investments to keep operating.
A statement of retained earnings shows profits you keep in the business after paying dividends. While it’s not a statement typically used by small businesses, it can tell a more detailed story about your business to potential investors and lenders.
The statement of retained earnings is like the epilogue to the story told in your income statement, cash flow statement and balance sheet. By showing how you’ve reinvested profits from your business, it provides a snapshot of your business’s financial health.