6 April 2011

Breaking Down The Retained Earnings Statement

This is part 4 of the financial statement series. The full series is Part 1, Part 2, Part 3, Part 4, Part 5

Now we’ve reached the Retained Earnings Statement. In Part 3 of this series, I spoke about the balance sheet and the formula which was ‘assets = liabilities + shareholders equity’. Let’s take a look at how the retained earnings statement works and break it down in greater detail.

The statement of retained earnings can also be referred to as ‘statement of shareholders equity’ or ‘equity statement’. It records the amount of money [equity] that the owners have in the business at the beginning and end of the period being looked at. It also includes the earning or losses during that period.

A very simple example would look this way:-

Retained Earnings =                              1000 +
Net Income =                                        500 -
Dividends =                                           200
Equals [Retained Earnings] =                  1300

Why is the retained earnings statement important?

Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial ReportsIt is important to pay close attention to the statement of retained earnings because of how it can affect the business. Once you have reached the stage where you want to sell your business for example, the amount of shareholders equity available in the business can act as the foundation for how much you decide to ask for, or how much they are willing to pay. Also when seeking investment in order to grow, the amount of equity it has will determine whether the money is ultimately given to you or not. 

One of the reasons for this is because it can act as a barometer for the amount of money available to pay down any debts the company has or to reinvest into the business. The calculation for this would look something like:-

Initial Retained earnings [+/-] net income – dividends = retained earnings

The net income figure displayed on the retained earnings statement is brought in from the income statement. Similarly, the ending balance recorded on the sheet is brought in from the statement of shareholders equity section on the balance sheet. 

We now begin to get an idea of how the different sections of the financial statement link. In the final instalment of the financial statement series, I will provide details on what I have discovered with regards to how all of the financial statements link together.

In the meantime, for further reading, I recommend you check out this highly comprehensive document on reading financial statements.

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