Step-by-Step Guide to Calculate Retained Earnings

Let’s say a SaaS startup, launched with an initial investment, earns revenue from subscription fees. At the end of its first year, after covering operational expenses, it reports a net profit of $100,000. 

Instead of distributing all profits to its founders or investors, the startup decides to reinvest $70,000 into product development and marketing while distributing $30,000 as dividends. The amount retained ($70,000) is what’s known as retained earnings.

Retained earnings are the accumulated profits a business keeps after covering expenses and distributing dividends. They indicate how much a company has reinvested into its operations rather than paying out to shareholders. For startups, retained earnings are crucial for scaling operations, funding growth, and maintaining financial stability.

In this guide, we’ll break down the retained earnings formula, explain its components, and show how startups can calculate and use retained earnings effectively.

‍

How to Calculate Retained Earnings

For startups, tracking retained earnings is essential to understanding how much profit is reinvested into the business versus distributed to investors. Unlike revenue, which represents total income, retained earnings reflect the portion of profits that remain after covering expenses and dividends. This amount helps startups fund future growth, manage cash flow, and strengthen financial stability.

The formula to calculate retained earnings is:

Ending Retained Earnings=Beginning Retained Earnings+Net Income−Dividends

Here’s what each component in the formula mean:-

• Beginning Retained Earnings: The retained earnings balance carried forward from the previous period. If the startup is in its first year, this amount is zero.
• Net Income: The profit after deducting all operating expenses, taxes, and costs. A higher net income increases retained earnings.
• Dividends: The portion of profits distributed to shareholders. Paying dividends reduces retained earnings.

Let’s understand it with an example. 

Consider a SaaS startup that began the year with $20,000 in retained earnings. Over the year, it generated a net income of $80,000 and decided to distribute $15,000 in dividends to investors. Using the formula:

Ending Retained Earnings=20,000+80,000−15,000=85,000

At the end of the year, the startup retains $85,000, which can be reinvested in growth initiatives such as hiring, marketing, or infrastructure improvements.

‍

Components That Affect Retained Earnings

Retained earnings fluctuate based on key financial components that impact a startup’s profitability and distribution decisions. Let’s take a look at a few of such components:-

1. Beginning Retained Earnings

This is the retained earnings balance carried forward from the previous period. For newly launched startups, this value is zero. In subsequent years, it reflects the accumulated profits retained over time.

2. Net Income (or Net Loss)

Net income is the profit a startup earns after deducting all expenses, including operating costs, salaries, taxes, and interest. A positive net income increases retained earnings, while a net loss reduces it.

Example:

• If a startup earns $50,000 in net income, retained earnings increase by the same amount.
• If it incurs a $10,000 loss, retained earnings decrease accordingly.

3. Dividends

Dividends represent profits distributed to shareholders. Startups often choose to reinvest earnings instead of paying dividends, but when dividends are issued, they directly reduce retained earnings.

Here are types of dividends:

• Cash Dividends - A direct payout that decreases retained earnings and cash reserves.
• Stock Dividends - Instead of cash, additional shares are issued, reducing retained earnings but not affecting cash flow.

‍

How Dividends Impact Your Retained Earnings

Dividends directly reduce retained earnings because they represent a portion of profits distributed to shareholders. Startups, especially in their early stages, often choose to reinvest earnings rather than distribute them. However, when dividends are issued, they affect retained earnings in different ways depending on the type of dividend.

1. Cash Dividends

Cash dividends are direct payouts to shareholders and immediately reduce both retained earnings and cash reserves.

Example - A startup with $100,000 in retained earnings declares a cash dividend of $20,000. After distribution, its retained earnings decrease to $80,000.

New Retained Earnings=100,000−20,000=80,000

2. Stock Dividends

Instead of cash, a company may issue additional shares to shareholders. While this does not reduce cash reserves, it reduces retained earnings as the company transfers a portion of earnings to equity.

Example - If a startup declares a 10% stock dividend on 10,000 outstanding shares, shareholders receive 1,000 new shares. The company records this as a reduction in retained earnings, with an offsetting increase in common stock and additional paid-in capital.

3. Special Dividends

These are one-time dividends, often declared when a company has excess profits. Like cash dividends, special dividends reduce retained earnings immediately.

For startups, deciding whether to distribute dividends or reinvest earnings is a strategic choice that impacts financial stability and growth potential.

‍

How to Record Retained Earnings in Your Books?

Accurate accounting for retained earnings ensures financial transparency and compliance. Startups must record retained earnings adjustments correctly as part of their financial reporting. Below are key journal entries to record in retained earnings accounting.

1. Year-End Closing Entry

At the end of each financial period, net income (or net loss) is transferred to retained earnings.

Example Entry (For Net Income of $50,000):

This entry moves profits from the income statement to the balance sheet under retained earnings.

2. Recording Dividend Declarations

When a company declares dividends, it creates a liability.

Example Entry (For Declaring $10,000 in Dividends):

This entry reduces retained earnings and records a payable amount to shareholders.

3. Dividend Payment Entry

Once dividends are paid, the payable account is settled.

Example Entry (When Paying Out Declared Dividends):

This reflects the reduction in cash after dividends are distributed.

4. Adjusting for Prior Period Errors

If errors are discovered in past financial statements, adjustments must be made to retained earnings.

Example Entry (For Overstated Income of $5,000 in the Previous Year):

This correction ensures accurate financial reporting.

Properly recording retained earnings helps startups track profitability, manage cash flow, and prepare for future growth.

‍

How Your Startup Can Use Retained Earnings?

Retained earnings give your startup the flexibility to grow without relying solely on external funding. Instead of taking on debt or giving up equity, you can reinvest profits back into your business. 

Here are some of the best ways to use retained earnings to drive growth and stability:-

1. Reinvest in Product Development

Use retained earnings to enhance your product, develop new features, or expand into new markets. Investing in innovation helps you stay competitive and attract more customers.

2. Scale Your Marketing and Sales Efforts

Expanding your reach requires investment in paid advertising, content marketing, and sales initiatives. With retained earnings, you can grow your customer base without seeking outside funding.

3. Strengthen Your Financial Reserves

Market conditions can be unpredictable, and having cash reserves helps you navigate downturns or unexpected expenses. A strong financial cushion ensures your startup remains stable.

4. Pay Off Debt

If your startup has loans, using retained earnings to reduce debt can lower interest costs and improve financial health. This allows you to reinvest more of your revenue into growth.

5. Fund Strategic Acquisitions

As your startup grows, you may find opportunities to acquire smaller businesses or complementary technology. Retained earnings provide a way to fund these acquisitions without external financing.

‍

What Are Negative Retained Earnings?

Negative retained earnings occur when a startup’s accumulated losses exceed the profits it has retained over time. This situation, also known as an accumulated deficit, signals financial challenges that require immediate attention. 

While some early-stage startups may operate with negative retained earnings due to initial investments in product development and market expansion, prolonged deficits can indicate deeper financial issues.

Causes of Negative Retained Earnings

A startup’s retained earnings can turn negative due to several factors. While some are temporary and part of a startup’s growth phase, others require careful financial management to prevent long-term issues.

• Consistent Losses - If your startup consistently reports net losses, retained earnings will continue to decrease, leading to a deficit over time.
• Large Dividend Payments - Distributing dividends without ensuring sufficient profitability reduces retained earnings and can push them into negative territory.
• High Operating Costs - Startups investing heavily in product development, marketing, or hiring without generating enough revenue may quickly deplete retained earnings.
• One-Time Unexpected Expenses - Unplanned costs, such as legal settlements, penalties, or failed product launches, can create a sudden drop in retained earnings.

How Negative Retained Earnings Affect Your Startup’s Growth?

Negative retained earnings can impact multiple areas of your business, from investor confidence to future financial decisions. While a deficit isn’t always an immediate crisis, it can pose significant challenges if not addressed.

• Reduced Investor Confidence - Investors and venture capitalists prefer financially stable startups. A growing deficit may make it harder to raise funds.
• Limited Growth and Expansion - With negative retained earnings, your startup may struggle to reinvest in research, hiring, and product development.
• Increased Debt Reliance - If retained earnings are insufficient to fund operations, you may need to take on loans, increasing financial risk.
• Regulatory and Compliance Challenges - In some cases, prolonged negative retained earnings may lead to restrictions from lenders or regulators, affecting financial flexibility.

Negative retained earnings do not necessarily mean a startup is failing, but they highlight areas that need immediate financial adjustments. Addressing these challenges proactively can help your business recover and sustain long-term growth.

‍

How to Recover from Negative Retained Earnings?

If your startup has negative retained earnings, taking the right steps to improve profitability and manage cash flow can help you regain financial stability. Below are actionable strategies to turn your accumulated deficit into a positive balance.

1. Increase Revenue Streams

Finding ways to boost revenue is the most effective way to offset negative retained earnings. Consider diversifying your offerings, optimizing pricing strategies, and improving customer retention.

2. Reduce Unnecessary Expenses

Review your operating expenses and identify areas where costs can be cut without compromising core operations. This could include streamlining processes, renegotiating vendor contracts, or optimizing marketing spending.

3. Limit or Pause Dividend Payments

If your startup distributes dividends, consider reducing or pausing them until retained earnings return to positive levels. Reinvesting profits into the business strengthens financial stability and supports long-term growth.

4. Secure Additional Funding

If revenue optimization and cost-cutting measures are not enough, seeking external funding can help stabilize finances. This could be in the form of venture capital, angel investment, or a business loan.

5. Optimize Pricing and Customer Retention

A well-structured pricing model and strong customer retention strategy can increase profitability. Consider adjusting your pricing strategy to reflect market demand and improve customer lifetime value.

‍

Restrictions on Using Retained Earnings

While retained earnings provide startups with a valuable source of internal funding, there are certain restrictions that can limit how these funds are used. These restrictions may be imposed by legal regulations, debt agreements, or strategic business decisions to ensure financial stability. Understanding these limitations can help you make informed financial decisions while maintaining compliance.

1. Legal and Statutory Restrictions

Certain jurisdictions require businesses to maintain a statutory reserve, meaning a portion of retained earnings must be set aside and cannot be freely used. These regulations exist to protect creditors and ensure companies have a financial cushion in case of unexpected challenges.

Example: A startup incorporated in a country with statutory reserve requirements may need to allocate 10% of its retained earnings to a legal reserve before distributing dividends.

2. Debt Covenant Restrictions

If your startup has taken loans, lenders may impose restrictions on how retained earnings can be used. These debt covenants are designed to ensure that companies maintain financial stability and prioritize loan repayments over discretionary spending.

Example: A venture-backed SaaS startup with a $500,000 business loan might be restricted from using retained earnings for large dividend payments until the loan is repaid.

3. Industry-Specific Regulations

Certain industries have regulations that dictate how much capital must be retained to ensure long-term financial health. This is especially relevant for fintech startups, insurance companies, and businesses operating in highly regulated sectors.

Example: A startup in the financial services industry may be required to maintain a minimum level of retained earnings to comply with regulatory capital requirements.

4. Strategic Business Considerations

Beyond external regulations, some startups impose internal restrictions on retained earnings to ensure they have enough capital for future growth. Founders and investors may decide to reinvest earnings instead of distributing dividends to shareholders.

Example: A B2B SaaS startup may choose to reserve 70% of its retained earnings for product development and only allocate 30% for discretionary expenses.

‍

How to Record Retained Earnings in Financial Statements?

Retained earnings appear in key financial statements, providing insight into a startup’s financial health and reinvestment strategy. Understanding how retained earnings connect to different financial reports helps you analyze your company’s growth trajectory and make informed decisions.

1. Balance Sheet

On the balance sheet, retained earnings are listed under the equity section alongside contributed capital and other equity accounts. It represents the cumulative profits that the startup has retained rather than distributed as dividends.

Example: If a startup has $200,000 in total assets and $50,000 in liabilities, and its retained earnings amount to $70,000, the balance sheet will reflect:

Assets = Liabilities + Equity  

$200,000 = $50,000 + ($70,000 Retained Earnings + Other Equity)

A growing retained earnings balance generally indicates profitability, while a negative balance signals financial challenges.

2. Statement of Retained Earnings

The statement of retained earnings is a standalone report that details how retained earnings change over a specific period. It includes the beginning balance, net income or loss, dividends, and the ending retained earnings balance.

Here is an example of format you can use

This statement helps investors and financial analysts understand how a startup is reinvesting profits.

3. Income Statement Connection

While retained earnings are not directly reported on the income statement, net income from this report is a key component in retained earnings calculations. Higher net income leads to increased retained earnings, whereas consistent losses result in a declining balance.

4. Cash Flow Statement Implications

Retained earnings differ from cash flow, but they are connected. While retained earnings indicate accumulated profits, the cash flow statement shows how much actual cash is available. A startup may have high retained earnings but low cash flow if profits are tied up in receivables or assets.

‍

Frequently Asked Questions

Why do I need to calculate retained earnings?

Calculating retained earnings helps track how much profit your startup has reinvested into the business rather than distributed as dividends. This insight is crucial for financial planning, investor reporting, and long-term growth strategies.

How often should I update my retained earnings calculation?

Retained earnings are typically updated at the end of each accounting period (monthly, quarterly, or annually) when financial statements are prepared. Regular updates ensure accurate financial reporting and strategic decision-making.

How do minimum retained earnings requirements work?

Some jurisdictions or industries require businesses to maintain a minimum level of retained earnings as a financial safeguard. This prevents excessive dividend payouts and ensures companies have reserves to cover liabilities and future expenses.

What causes negative retained earnings?

Negative retained earnings occur when accumulated losses exceed profits. This can result from consistent net losses, large dividend payments, high operating costs, or one-time financial setbacks.

What’s the difference between retained earnings and cash?

Retained earnings reflect accumulated profits, while cash represents actual available funds. A startup can have high retained earnings but low cash flow if profits are tied up in receivables, inventory, or other assets.