Net Profit vs. Retained Earnings: Key Concepts for Small Business Owners (2024)

Unsure about how to manage your finances effectively? Check out our article on net profit and retained earnings and understand why retained earnings are crucial for long-term growth. Small Business

Understanding Retained Earnings in Business:

• What are they? Retained earnings are the remaining profits after dividends are paid to shareholders. They reflect the net earnings held back in the company to reinvest or cover future dividends.
• Importance: Retained earnings give a more comprehensive insight into a business's health than just monthly net profit. They guide decisions on reinvestment or dividend payouts and are vital for investors and lenders.
• Net Income Vs. Retained Earnings: Net income is the profit after all expenses. Retained earnings are what remains after dividends are paid from this net income.
• Calculating: Use the formula: Beginning Retained Earnings + Net Income – Dividends = Retained Earnings.
• Accumulated Deficit: When a company has a positive net income but negative retained earnings due to large dividend payouts.
• Net Loss: When expenses exceed revenues, leading to a negative balance after considering dividends.
• Relation with Shareholder Equity: Retained earnings directly impact shareholders’ equity, representing the company’s net worth.
• Creating a Retained Earnings Statement: A step-by-step guide includes creating a heading, calculating the beginning amount, adding net income, subtracting dividends, and deriving the total.

Why are retained earnings important for your Small Business?

• Lenders and investors will consider retained earnings even more than net income when deciding whether to trust you with their money.
• It gives you a clearer picture of your business than just looking at monthly net profit figures, which can vary quite a lot depending on a wide range of factors.
• It also indicates if and how you should invest money back into your business.
• If the number is low, it’s better to keep the money in the business as a cushion against cash flow problems rather than handing it out as dividends.
• If both are substantial, it’s time to invest in growing your business, perhaps with new equipment or facilities.
• Your net profit and retained earnings can help you gauge your company’s financial health.