Aside from capital, profits are one of the most critical factors affecting a business’s ability to continue operating and generating profits. There are several profit models, such as gross profit or pre-tax profit. In addition, they are also known as retained earnings.
The company retains profit from the remaining net income and does not pay it to shareholders. Holding profits against the remaining net income after dividends are distributed by the company. The amount of retained earnings is stated in the company’s financial statements, especially in the income statement. The calculation of the profit share is to divide the profit into share ownership (dividends) and the profit that the business saves to reinvest in the company. You can automate cash flow management, financial statement creation, to the amount of profit and loss with the best Accounting Software from us.
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Table of Content
Retained Earnings: What You Should Know
Retained earnings are part of the net income that is retained. The company does not pay dividends to investors as a precautionary fund, extra reserve capital, or to meet investment needs. Retained earnings are also referred to as retained earnings.
In short, retained earnings can also have the meaning of residual net income reduced in dividends. Dividends are the distribution of profits by a business to its shareholders proportional to their shareholding.
This retained earnings decision occurred on a joint decision at the General Meeting of Shareholders (GMS). The company’s financial situation is a reference for decision-making, marketing strategies, and future operational funding requirements.
Changes in corporate taxes, production costs, sales costs, and the cost of goods, changes in net income, changes in the number of dividends a company has to pay to shareholders, and changes in administrative costs impact profitability.
The function of Retained Earnings
Retained earnings are not without cause and purpose. There is a particular urgency that makes all shareholders agree not to give the company dividend rights. Here are its functions and objectives:
1. Assist with debt servicing for businesses
If the business does have significant debt, investing the retained profit is hugely profitable. Because the business’s accountant can make debt payments on time by utilizing the remaining profits, repaying its obligations will not affect the company’s other funding sources, ensuring the security of the company’s primary funds.
2. For the operation of the business’s financing
A business must have an adequate supply of cash, both large and small. The company can use retained earnings to fund operations, allowing it to continue operating in the hope of expanding.
This is frequently the case when a business’s profits are small and would be much better-spent financing operations than distributed to shareholders. However, it requires shareholder approval.
3. In the capacity of reserve capital
Additionally, profit funds serve as capital reserves if the business encounters financial difficulties. Reserve funds are used to supplement existing funds for companies to continue operating effectively without borrowing money from third parties such as banks.
4. For business development
Additionally, retained earnings serve as a source of reserve funds for the company’s finances during financial distress. Profit holding of its use can also serve as a form of business development capital. In this business development, we don’t have to limit building construction; it can also include the human resources of the company.
Also Read: Discover 10 Effective Business Expansion Strategies
5. The company’s future investment capital
Of course, business owners want a business that is not static or declining but wants growth and innovation to survive and thrive. Another profit-holding advantage is to expand the business or make an investment.
Factors Causing Retained Profit
Several factors contribute to the occurrence of restrained profits, including the following:
1. There is a change in the company’s management
If the company’s control or management changes, existing profits are usually maintained. This is done to allow the new management to adjust and demonstrate the credibility of its financial management. Gains are born in these cases to ensure job stability, suppress acts of suspicion or fraud, and so on.
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2. There was an error in the previous period’s financial statements
Another factor is the occurrence of errors in the financial statements of the previous period. In this case, the company must first improve the financial statements so that they are valid, after which only take into account the value of the earnings statement adequately held.
3. There is an adjustment in the value of the rupiah from the previous period
The adjustment of the rupiah value is also an influential factor. The rupiah exchange rate can fluctuate at any time, affecting the company’s profit calculation results. Thus, accountants choose to maintain existing profits.
4. Changes in the calculation method
The change in the calculation method can also contribute to retained earnings. For example, if the previous calculation method is always every month and then switches to weekly, it won’t be evident. Accountants will usually withhold existing capital gains due to ambiguous data.
5. Changes in accounting principles from the previous period
In addition, changes in accounting principles from the prior period may affect the value of retained earnings statements. For example, when the business begins to adopt Sharia accounting in the next period, bookkeeping and results must apply Sharia law.
The formula for Retained Earnings Calculation
You have to compile retained earnings to become one of the essential financial statements for the company regularly. The ability of a business to operate effectively and achieve its business objectives depends on the quality of these reports.
As a result, you must first understand how to calculate retained earnings, namely as follows:
Step 1: Calculate gross profit
The calculation of the first component is the gross profit or profit that the business earns from sales, namely as follows:
GROSS PROFIT = SALES FIGURE – COST OF GOODS
Step 2: Calculate operating profit
If you have earned the amount of gross profit, the next is to calculate the company’s operating profit using the following formula:
OPERATING PROFIT = GROSS PROFIT – OPERATING EXPENSES
Step 3: Calculate net income before tax
The next step in determining retained earnings is determining net income before taxes. These calculations are by subtracting interest, amortization, and depreciation of operating profit.
NET INCOME BEFORE TAX = OPERATING INCOME – (INTEREST+ AMORTIZATION+DEPRECIATION)
Step 4: Calculating taxable net income
How to calculate net income after tax you can use the following formula:
NET INCOME AFTER TAX = NET INCOME BEFORE TAX – TAX RATE
Step 5: Calculate retained earnings
Once you know the company’s net income in a certain period, you can calculate how much retained profit the company can make, namely:
RETAINED EARNINGS = NET INCOME AFTER TAX – DIVIDENDS
Also Read: Importance of DuPont Analysis for Corporate Financial Management
Conclusion of Retained Earnings
Calculating retained earnings manually will take time and effort. There is a possibility of incorrect numbers due to human error; however, you can minimize or eliminate such errors by utilizing Accounting Software.
Starting from cash flow management, calculating retained profits, making financial statements, bank reconciliation, adjustment journals, invoice creation, and making reports more effortless and automatic. We have provided practical solutions for hundreds of large companies in Indonesia and Singapore. Get a free demo of the software and move to HashMicro now.
