Funding a Small Business: Learning About the Importance of Retained Earnings for Your Business

13 Apr
Retained earnings for your small business

One of the key financial indicators lenders and investors look at when evaluating a business is retained earnings. Retained earnings show lenders and investors how you handle your net profits, specifically the amount of profits you reinvest in your business. In this article we will learn the importance of retained earnings for your business.

What Are Retained Earnings?

Retained earnings are annual profits that you reinvest in your business. The principle is simple - when you earn a net profit (calculated as revenues minus expenses), you have two choices:

  1. Take profits as a cash distribution and/or
  2. Reinvest profits into the business

Your retained earnings grow each year by the amount of profit you chose to reinvest.  These cumulative profits reinvested in your business – retained earnings – are reported on your balance sheet in the equity section.

Retained Earnings Equation

How do retained earnings work?

Let’s say you opened a business on January 1, 2015. By the end of 2015, you earned $20,000 in profit (earnings). You decide to: 

  1. Reward yourself with a $5,000 cash distribution for all your hard work and
  2. Reinvest the remaining $15,000 to make improvements to the business.

At the end of the year, your retained earnings look like this:

Retained Earning Summary

Beginning retained earnings (Jan. 1)

    $ 0

+ Profit (Loss)

+   $20,000

- Cash distributions to owner

-   $   5,000

Ending retained earnings (Dec. 31)

   $ 15,000

 

Why Do Lenders and Investors Care About Retained Earnings?

The way you handle profits over time is an important factor for lenders and investors. They generally expect to see your retained earnings grow over time and add value to your business. Positive retained earnings reflect a commitment to sustain and grow a business, whether it is through investing in new equipment or technology, or expanding the business operation. Negative retained earnings can indicate one of two things: (1) the business has experienced more losses than profits over time or (2) the owner is more focused on taking cash distribution than investing in future business growth.  Lenders and investors generally avoid dealing with companies that have negative equity. 

Did You Know…

The words “earnings” and “profits” mean the same thing. Therefore the terms “retained earnings” and “retained profits” both signify profits that were reinvested in a business.

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About Excelsior Growth Fund

Excelsior Growth Fund (EGF) helps businesses in New Jersey, New York and Pennsylvania grow by providing streamlined access to business loans and advisory services. EGF’s signature product, the EGF SmartLoan™, provides up to $100,000 in fast, transparent, and affordable financing through a secure online platform. Larger loans up to $500,000 are also available. EGF is a nonprofit organization and is certified by U.S. Department of Treasury as a Community Development Financial Institution (CDFI). Learn more atwww.excelsiorgrowthfund.org