The Statement of Retained Earnings reconciles the Retained Earnings account from the beginning to the end of the fiscal year.
Retained earnings represent the amount of profit a business reinvests in itself (i.e., the profit that is not used to pay back debt or distributed to shareholders as a dividend). It is important to note that the statement only includes information on the company’s profits that are not paid out as dividends.
This information is reported on the Statement of Retained Earnings when a corporation announces earnings or declares dividends. The net income raises the account for retained earnings. Retained Earnings are decreased by net losses and dividends.
The Statement of Retained Earnings contains no information that is not reflected in other financial statements. However, it provides extra information regarding management’s use of the company’s earnings.
What is the Importance of a Statement of Retained Earnings?
The statement is used to track the amount of earnings that a company has available to reinvest in its business. It is also a key tool for financial planning and forecasting, as it can help management to understand how much of the company’s earnings are being reinvested.
Management may reinvest a portion or all of the company’s net income by retaining earnings, distributing current income to shareholders, or distributing current and cumulative income to shareholders. (Investors can utilise this information to align their investment plan with management’s strategy.
An investor seeking growth and returns on capital may be more willing to invest in a company that reinvests its resources to generate further resources. In contrast, an investor seeking present income is more likely to invest in a company that distributes quarterly dividends to shareholders.
Key Components of the Statement
Every Statement of Retained Earnings follows a logical structure. It starts with opening retained earnings, which equal the closing balance from the previous accounting period. The statement then incorporates net profit or net loss from the current income statement. This figure represents the main driver of change.
Next, the statement adjusts for prior-period items, such as corrections of accounting errors or changes in accounting policies. These adjustments ensure accuracy and comparability across reporting periods. Finally, the statement deducts dividends declared, whether interim or final. The remaining balance represents retained earnings carried forward.
Things to be Taken Care of Statement of Retained Earnings
The resulting balance is the company’s ending retained earnings balance, which is carried forward to the next period. The statement of retained earnings is important because it shows how a company is using its profits to reinvest in its business or to pay out to shareholders.
There are a few key things to keep in mind when reading a statement of retained earnings. First, remember that net income is not the same as cash flow. Net income includes items such as depreciation and amortisation, which are non-cash items. So, even though a company may have generated positive net income, it may not have had positive cash flow.
Second, remember that dividends are not deducted from net income but are instead deducted from retained earnings. So, if a company has positive net income but negative retained earnings, the company is paying out more in dividends than it is earning.
Third, the statement of retained earnings only covers one period of time. So, you will need to look at multiple statements to see how a company has performed over time.
Finally, remember that the retained earnings statement is a snapshot in time. It does not reflect the current value of the company’s assets or liabilities. Nor does it reflect the current market value of the company’s shares.
Limitations of the Statement of Retained Earnings
Despite its usefulness, the Statement of Retained Earnings has limitations. It does not indicate how retained profits are invested or whether those investments generate value. The statement also does not show cash availability, as retained earnings include non-cash profits such as accrued income.
Furthermore, a high retained earnings balance does not guarantee financial strength. Loss-making companies may still report positive retained earnings due to strong past performance. Therefore, users should interpret this statement alongside cash flow statements and profitability ratios.
Conclusion
The Statement of Retained Earnings explains how a company manages its accumulated profits over time. As it highlights the relationship between net income, dividends, and stockholders’ equity, it provides perspective into dividend policy and practice as well as financial prudentness and practice. Despite not articulating how income is allocated, it is an essential instrument in grasping long-term financial activity. Taking into perspective other accounting statements, it allows informed judgment to be made regarding stability and expansion prospects of any firm.
