Explain the relationship between retained earnings, net income and dividends

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For example, if your profit margin is 25%, your company keeps $0.25 for every dollar spent. Most companies are pedantic about increasing their revenue. But they’re even more concerned about profits—and, more specifically, what portion of those profits can be used for growth. For accounting firms to streamline the spend and expense management of your clients making life easier for you and them.


She is a Certified Public Accountant with over 10 years of accounting and finance experience. Though working as a consultant, most of her career has been spent in corporate finance. Helstrom attended Southern Illinois University at Carbondale and has her Bachelor of Science in accounting. For example, during the period from September 2016 through September 2020, Apple Inc.’s stock price rose from around $28 to around $112 per share. It can be invested to expand existing business operations, like increasing the production capacity of the existing products or hiring more sales representatives.

Retained Earnings Explained

There are only three items that impact retained earnings, net income, cash dividends, and stock dividends. Retained earnings, as its name implies, is a equity account that mainly comprises a company’s cumulative, undistributed earnings. The main difference between retained earnings and profits is that retained earnings subtract dividend payments from a company’s profit, whereas profits do not. Where profits may indicate that a company has positive net income, retained earnings may show that a company has a net loss depending on the amount of dividends it paid out to shareholders. It is recorded into the Retained Earnings account, which is reported in the Stockholder’s Equity section of the company’s balance sheet. The amount is usually invested in assets or used to reduce liabilities.

Which of the following will not affect retained earnings?

Explanation: Land purchase does not affect the retained earnings account.

Though retained earnings are not an asset, they can be used to purchase assets in order to help a company grow its business. A Limited Liability Company, referred to as an LLC, is a type of corporate structure where individual shareholders are not personally liable for the company’s debts. Like in a general partnership, profits of an LLC are generally distributed to the shareholders.

How to create your own retained earnings statement

Retained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements. This reinvestment into the company aims to achieve even more earnings in the future. When a corporation announces a dividend to its shareholders, the retained earnings account is decreased. Since dividends are distributed on a per share basis, retained earnings is decreased by the total of outstanding shares multiplied by the dividend rate on each share of stock. While a board of directors may declare dividends on both common and preferred shares of stock, dividends on preferred shares of stock receive preference in order of payment.


The primary elements that affect retained earnings are net income/ net loss and dividend payments. It doesn’t matter which accounting method you’re using, you can still create a retained earnings statement. The only difference is that accounts receivable and accounts payable balances would not be factored into the formula, since neither are used in cash accounting. In companies that are mature, it is common for management to make regular shareholder distributions, either in the form of cash dividends or stock dividends. These have an immediate and irreversible impact on retained earnings as distributions cannot be clawed back from shareholders once they are made.

Retained Earnings vs Net Income

These funds may be reinvested back into the business by, for example, purchasing new equipment or paying down debt. Healthy retained earnings are a sign to potential investors or lenders that the company is well managed and has the discipline to maintain solid unit margins. Find your retained earnings by deducting dividends paid to shareholders from the sum of your old retained earnings balance and net income for the current period. Many factors affect an entity’s retained earnings, and these effects could increase or decrease accordingly.

  • Some factors that will affect the retained earnings balance include expenses, sales revenues, cost of goods sold, depreciation, and more.
  • Like in a general partnership, profits of an LLC are generally distributed to the shareholders.
  • Plus, the company board decides to pay $1,500 as a dividend to shareholders.
  • Retained earnings increase when the company earns a profit during the accounting period.
  • A company’s revenue is reported on an income statement.

Below is a short video explanation to help you understand the importance of https://bookkeeping-reviews.com/ from an accounting perspective. Companies may choose to use their retained earnings for increasing production capacity, hiring more sales representatives, launching a new product, or share buybacks, among others. With net income, there’s a direct connection to retained earnings. However, for other transactions, the impact on retained earnings is the result of an indirect relationship. Cost of goods sold, which is the direct costs attributable to the production of the goods sold in a company.

Net income directly affects retained earnings, hence a large net loss will decrease the retained earnings account. The ending balance of retained earnings from that accounting period will now become the opening balance of retained earnings for the new accounting period. The simplest way to know your company’s financial position is with an expense management platform that tracks operational activities in one place.

  • A Limited Liability Company, referred to as an LLC, is a type of corporate structure where individual shareholders are not personally liable for the company’s debts.
  • In the case of an individual, it comprises wages or salaries or other payments.
  • Let’s get into the details of how to prepare this financial statement.
  • The deduction can be before or after the addition of net income.