Retained Earnings: Formula, Statement and Examples

Retained earnings are the cumulative profits a company has kept since it began, after paying dividends to shareholders. The formula is simple: beginning balance plus net income minus dividends equals ending balance. The figure sits in the equity section of the balance sheet and links the income statement to the balance sheet each year.

This guide shows the retained earnings formula with worked numbers, how to prepare a statement of retained earnings, the closing entries that move profit into equity, and how the picture differs for sole traders and partnerships. It complements our guides to the small business balance sheet and the general ledger.

What the balance represents

Think of the equity section as the owners' claim on the business. It has two main sources:

• Contributed capital: money the owners put in, such as share capital.
• Earned capital: profit the business generated and did not hand back to owners. That is this account.

Every year the net income from the profit and loss statement is added to the balance, and any dividends declared are taken off. Over time it tells you how much of the business's equity was built by its own operations rather than by owner investment.

It is not a cash balance. The profits may have gone into equipment, stock, loan repayments or invoices that customers have not paid yet. A company with $200,000 of accumulated profit and $5,000 in the bank is not unusual.

How it differs from net income, revenue and cash

Measure	What it shows	Statement	Time frame
Revenue	Income earned from customers	Profit and loss	One period
Net income	Revenue minus all expenses	Profit and loss	One period
Accumulated profit kept	All past net income minus all dividends	Balance sheet (equity)	Since the business began
Cash	Money in the bank and on hand	Balance sheet (assets)	At one date

Revenue and net income reset each year; the equity balance does not. Cash can move in a completely different direction from profit, for example when customers pay slowly or the business buys equipment. That is why owners should read the balance sheet, profit and loss and cash flow statement together rather than relying on one figure.

The retained earnings formula

The standard formula is:

Ending balance = Beginning balance + Net income (or minus net loss) - Dividends declared

Worked example. Brightline Studio Ltd, a small incorporated agency, has these figures for the year:

Item	Amount
Opening balance (January 1)	$84,000
Revenue	$250,000
Total expenses including tax	$213,500
Net income ($250,000 - $213,500)	$36,500
Dividends declared	$12,000
Closing balance ($84,000 + $36,500 - $12,000)	$108,500

If Brightline had instead made a $20,000 loss and still paid $12,000 of dividends, the closing figure would be $84,000 - $20,000 - $12,000 = $52,000. Losses and distributions both reduce the balance.

You can also work backwards. If you know the opening and closing balances and the dividends, net income is the difference: closing minus opening plus dividends. That is a handy check when the profit and loss and balance sheet come from different sources.

Five-year example: how the balance builds

A single year shows the mechanics. Several years show the story. Here is Brightline's history from incorporation, before the prior period adjustment shown in the statement below:

Year	Opening balance	Net income (loss)	Dividends	Closing balance
Year 1	$0	($18,000)	$0	($18,000)
Year 2	($18,000)	$22,000	$0	$4,000
Year 3	$4,000	$41,000	$6,000	$39,000
Year 4	$39,000	$55,000	$10,000	$84,000
Year 5	$84,000	$36,500	$12,000	$108,500

Year 1 opened with a deficit, which is common for a new business buying equipment and building a client list. No dividend was paid until the deficit had been cleared and profits were steady. Year 5 profit fell, but the owners still took a larger dividend, so the retention ratio dropped. None of these figures is wrong, but laid out like this they invite good questions: why did profit fall, and is the dividend policy still right?

Statement of retained earnings

The statement of retained earnings is a short schedule that shows the movement in the balance during the period. Larger companies usually present it within a statement of changes in equity; small companies often prepare it as a one-page reconciliation. Here is Brightline's version:

Brightline Studio Ltd: statement for the year ended December 31	Amount
Balance at January 1	$84,000
Prior period adjustment (correction of prior year error, net of tax)	($1,500)
Adjusted opening balance	$82,500
Add: net income for the year	$36,500
Less: dividends declared	($12,000)
Balance at December 31	$107,000

The prior period adjustment line appears only when a material error in an earlier year's accounts is corrected. Here, the company discovered it had understated last year's expenses by $1,500 after tax, so the opening balance is restated. Routine changes in estimates, such as an accrual that turned out slightly higher than expected, go through the current year's profit and loss instead.

How net income gets there: closing entries

Revenue and expense accounts are temporary. At year end they are closed, their balances are transferred to equity, and they start the new year at zero. Using Brightline's figures, the closing entries are:

Step	Account	Debit	Credit
1. Close revenue	Revenue	$250,000
	Income Summary		$250,000
2. Close expenses	Income Summary	$213,500
	Expense accounts (total)		$213,500
3. Close income summary	Income Summary	$36,500
	Retained Earnings		$36,500
4. Close dividends	Retained Earnings	$12,000
	Dividends Declared		$12,000

Most accounting software does this automatically when you roll into a new financial year. You will not see the individual entries, but the effect is the same: the profit and loss starts at zero and the equity balance carries the year's result. This is also why a post-closing trial balance contains only balance sheet accounts.

The dividend itself is recorded when declared, with a debit to Dividends Declared (or directly to the equity account) and a credit to Dividends Payable, then cleared to cash when paid. Dividends are never an expense.

Where it appears on the balance sheet

Equity section (Brightline, December 31)	Amount
Share capital	$10,000
Retained earnings	$107,000
Total equity	$117,000

Total equity must equal total assets minus total liabilities. If the balance sheet does not balance after year end, an incorrect roll-forward of this account is one of the first things to check.

Negative balances: the accumulated deficit

When accumulated losses plus dividends exceed accumulated profits, the balance turns negative and is usually labeled an accumulated deficit. Startups often run deficits for years while they invest ahead of revenue; their equity is propped up by share capital raised from investors.

A deficit matters for three reasons:

1. Dividends. Company law in many countries restricts dividends to available distributable profits. Paying dividends while in deficit can be unlawful. Check with a qualified adviser before declaring any dividend.
2. Lending. Banks look at equity and accumulated losses when assessing credit. Some loan agreements include minimum equity covenants.
3. Trend. A shrinking deficit shows the business is now profitable; a growing one shows it is still burning through invested capital.

Sole traders, partnerships and LLCs

The concept is the same everywhere, but the account names change by business structure.

Structure	Where profit accumulates	Owner withdrawals
Sole proprietor	Owner's capital account	Owner's drawings
Partnership	Each partner's capital account, per the agreement	Partner drawings
Limited company or corporation	Retained earnings	Dividends (plus salary through payroll)
LLC (United States)	Depends on tax classification; often member capital accounts	Member distributions

Sole trader example. A freelance photographer starts the year with $20,000 in her capital account, makes a net profit of $45,000 and takes $38,000 out for personal living costs. Her capital account rolls forward like this:

Owner's capital	Amount
Opening capital	$20,000
Add: net profit for the year	$45,000
Less: drawings	($38,000)
Closing capital	$27,000

The arithmetic is identical to the corporate formula, with drawings in place of dividends. The difference is legal and tax-related: drawings are not a separate taxable payment in the way a dividend can be, because a sole trader is generally taxed on the business profit itself. Ask a qualified adviser how this works where you are registered.

Many accounting apps still show a line labeled with the corporate term for unincorporated businesses, because the software closes each year's profit to an equity account by default. If you are a sole trader, treat that line as part of your owner's equity and ask your accountant whether it should be closed to capital at year end.

Accounting choices that change the figure

Because the balance accumulates every profit and loss result, anything that moves profit between years also moves it. The main levers are timing adjustments:

• Accruals. Recording costs incurred but not yet billed lowers this year's profit. See our guide to accrued expenses.
• Prepayments. Spreading annual payments over the months they cover shifts cost into later periods. See prepaid expenses.
• Depreciation. The method and useful life chosen for equipment spread its cost over several years.
• Revenue recognition. Recording income when it is earned rather than when it is invoiced or paid.

Over the life of the business these choices even out, but in any single year they can make a noticeable difference. Every entry behind them should be documented, as described in our journal entries guide.

Retention ratio: how much profit you keep

The retention ratio shows what share of the year's profit stayed in the business:

Retention ratio = (Net income - Dividends) / Net income

For Brightline: ($36,500 - $12,000) / $36,500 = $24,500 / $36,500 = about 67.1%. The other 32.9% was paid out, which is the dividend payout ratio. A business planning to hire, buy equipment or build a cash buffer will usually keep a higher share. There is no universally correct level; it depends on your growth plans, debts and what owners need.

A useful habit is to decide the dividend after looking at three numbers together: this year's profit, the cash the business needs over the next six to twelve months, and the accumulated profit available. A company can be profitable on paper and still short of cash if customers pay slowly, so a payout that looks affordable from the profit and loss may not be from the bank balance.

Common mistakes

• Treating the balance as available cash. Check the bank and the cash flow statement before planning a dividend.
• Posting day-to-day transactions directly to equity. Only closing entries, dividends and genuine prior period corrections should touch the account.
• Recording dividends as an expense. They are distributions of profit, not a cost of earning it.
• Editing closed years. Changing a transaction in a closed year silently changes the opening equity of the current year. Lock prior periods in your software.
• Ignoring a growing deficit. It affects dividend capacity and borrowing.

Next step

Profits, and therefore the equity you build, depend on billing promptly and collecting what you are owed. Clean, consistent invoices make revenue easier to record and reconcile. Create professional invoices in minutes with our free invoice generator, and explore more guides on the cash flow statement and business finance.