Retained Earnings

One little description, so much power. The description of Retained Earnings on the SL CapEx template balance sheet formerly read

"TAKE DIRECTLY FROM LINE 523 of INCOME STATEMENT"

And this description can still be found on a few of the financial statements running around CapEx. The unfortunate part about this description is that it is wrong. (For one, the income statement only goes to row 53 in Excel, so that should be a first clue that something is odd.)

Retained Earnings is an account in the Equities Section of the Balance Sheet. It is a cumulative (read that word again - cumulative) account of all earnings that a company has retained since inception - hence the name "retained earnings." The tricky part about this account is that it is cumulative. In order to calculate Retained Earnings (RE) correctly, you must do it from the start.

Let's think about how to calculate RE. The first question is, "What is earnings?" Most would agree that earnings can be calculated as Revenues - Expenses. The Income Statement labels that number as "Net Income," so we'll refer to earnings as Net Income (NI).

The next question is, "How does a company retain earnings?" It's actually easier to address how a company does not retain earnings, and that is by paying dividends. When a company pays a dividend, then it is distributing part of its earnings out to its shareholders, who receive them. Therefore, the part NOT paid in dividends is the part of earnings that is retained. We'll call dividends "Div."

So, then we have a formula:

Retained Earnings = Net Income - Dividends
RE = NI - Div

(The second equation is the same as the first, but in the shorthand I noted above.) This is the exact formula that is calculated on the Income Statement, Line 53 (in the template I'm using).

The problem is that this RE is not equal to the RE on the Balance Sheet. The RE on the income statement represents the CHANGE in RE for this period on the Balance Sheet. Here's an example:

April 2008: Retained Earnings is calculated to be L$1,200
May 2008:

• Company has NI = L$1,500 and pays Div = L$1,000
• RE on the Income Statement is calculated as NI - Div = L$1,500 - L$1,000 = L$500
• RE on the Balance Sheet is calculated as RE(old) + RE(new) = L$1,200 + L$500 = L$1,700.

We can also write out a formula for RE on the Balance Sheet. It goes:

RE(t) = RE(t-1) + NI(t) - Div(t)

In words: Retained Earnings this period equal Retained Earnings last period plus net income this period minus dividends this period.

I hope that clears up some of the mystery with this line on the Balance Sheet. I see a lot of companies with incorrectly calculated RE, and it's really a pretty simple line to do. If you have any questions, feel free to leave a comment - anyone can.