What should I know about retained earnings (RE)?

Retained earnings are more than just numbers on a balance sheet; they represent a reserve of over $60 billion for Canadian companies. But what exactly are retained earnings and why are they important to your business?

This article explores not only the definition and calculation of retained earnings, but also how they can be used strategically to fuel your company's growth. Why should companies reinvest their profits instead of paying dividends?

What is Retained Earnings?

Retained earnings is the fundamental element of all of a company's financial statements, including the balance sheet, income statement, and cash flow statement. Retained earnings refers to the portion of retained earnings that is not distributed to shareholders in the form of dividends or other distributions.

These accumulated resources are strategically reinvested to support expansion, fund new product development or enhance financial stability in times of economic uncertainty. This reinvestment plays a critical role in enabling the company to pursue its long-term goals without excessive reliance on external sources of financing.

What does Retained Earnings do for a Company?

Retained earnings serve several important functions within a company:

Self-financing capability: Retained earnings provide the ability to fund internal projects, reducing dependence on external financing and unstable market conditions.

Financial flexibility: They provide the flexibility to deal with the unexpected and to quickly seize strategic opportunities.

Indicator of financial health: a high level of retained earnings is often perceived as a sign of good management, which can boost the confidence of investors and partners.

Strategic use of Retained Earnings for Business Owners

Business owners can use retained earnings wisely to optimize their company's tax strategy.

Reinvesting profits keeps resources within the company, allowing for continued development without relying on external sources of financing. This strategy can also increase the value of the company over the long term, providing shareholders with superior returns in the future.

Smart reinvestment: Use retained earnings to fund initiatives that increase long-term shareholder value, such as innovation or geographic expansion.

Prepare for the future: Build a reserve of retained earnings to protect your company against difficult economic times.

How is Retained Rarnings Calculated?

Retained earnings are calculated at the end of the fiscal year. The process begins with the company's net income, from which dividends paid to shareholders are subtracted. The remainder is added to the retained earnings account on the company's balance sheet.

A properly completed retained earnings account at the end and beginning of the corporation's fiscal year is required for your taxes. At T2inc.ca, retained earnings are part of the documentation required to complete your corporate income tax return. So remember the importance of these numbers!

Calculation Process

Determine net income: at the end of the fiscal year, the company calculates its net income, which is the total income less costs, expenses, interest and taxes.

Deduct distributed dividends: from this net income, the company deducts the amount of dividends that it has decided to distribute to its shareholders during the year.

Add to retained earnings: The amount remaining after the distribution of dividends is added to the retained earnings account.

Practical Example

Suppose a company, Tech Innovations Inc., achieves net income of $100,000 for the year 2023. At the annual shareholders' meeting, it is decided to pay a dividend of $20,000 to the shareholders to maintain their confidence and support the stock price.

Net income: $100,000

Dividends paid: $20,000

Balance transferred to retained earnings: $100,000 - $20,000 = $80,000

This $80,000 is carried forward to the retained earnings account on the balance sheet, increasing the company's equity.

Make the Most of Retained Earnings to Secure your Company's Future

Retained earnings are more than just a number on the books; they're a lever for growth and security in your business. At T2inc.ca, we stress the importance of properly documenting retained earnings to effectively complete your corporate tax return. These records help demonstrate the retention of earnings for reinvestment, which can influence shareholder tax assessments and investment decisions.

For customized assistance, consider T2inc.ca, your tax and accounting partner. Our partners can help you make the right use of your retained earnings. Contact us to find out how we can help you achieve sustainable success for your business.

This article is intended to be an informative and accessible resource for all business owners who want to master the financial management of their business.