Understanding Changes in Equity Due to Retained Earnings

What Are Retained Earnings?

Retained earnings represent the cumulative amount of net income that a company has retained, rather than distributed as dividends to shareholders. They form a key part of the equity section of a company’s balance sheet and are vital for understanding the company’s growth potential.

Example 1: Basic Calculation of Retained Earnings

Consider a company, XYZ Corp, with the following financial data:

• Beginning Retained Earnings: $100,000
• Net Income for the Year: $50,000
• Dividends Paid: $10,000

To calculate the ending retained earnings:

1. Calculate the Total Retained Earnings:

   \[ \text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends Paid} \]
   \[ \text{Ending Retained Earnings} = 100,000 + 50,000 - 10,000 \]
   \[ \text{Ending Retained Earnings} = 140,000 \]

2. Statement of Changes in Equity:

   Component	Amount
   Beginning Retained Earnings	$100,000
   Add: Net Income	$50,000
   Less: Dividends Paid	($10,000)
   Ending Retained Earnings	$140,000

Example 2: Changes in Retained Earnings Over Multiple Years

Suppose that XYZ Corp has the following retained earnings information over three years:

• Year 1: Retained earnings increased due to a net income of \(50,000, despite dividends of \)10,000.
• Year 2: The company performed even better, with net income rising to \(70,000, resulting in retained earnings of \)195,000 after paying $15,000 in dividends.
• Year 3: A slight dip in net income to \(60,000 still contributed positively to retained earnings, which ended the year at \)235,000.

Conclusion

These examples illustrate how retained earnings affect the statement of changes in equity. By analyzing the impact of net income and dividends, you can see how a company’s profitability directly influences its equity profile. Understanding this relationship is essential for both investors and company management to assess financial health and growth potential.