What is net income vs retained earnings?
In this post, we’ll be going through these two important terms related to company profits. We will cover how to calculate them, what the differences between them are, the types of earnings and income, why they are important, and more.
What is Net Income?
Net income is commonly referred to also as net profit or net earnings. This is the amount of money you refer to as earnings after you have subtracted all expenses and other deductibles. These expenses include CoGS (cost of goods sold), taxes, marketing expenses, payroll, operation expenses, among others. Some refer to net income as the “bottom line” because it appears at the bottom of financial statements.
A company may have a higher net income in proportion to its expenses. In this case, you would see that the business is profitable and likely very financially healthy and stable.
How to Calculate Net Income
Before you can calculate your net income, you need to know your revenue, gross income or gross profit, and expenses.
Revenue is the amount of money you earn from sales or services. Essentially, it is how much you make through the operation of your business.
Gross income is the amount left over after you subtract the CoGS or the cost of sales or production. When you subtract tax deductions from gross income, you get taxable income.
As mentioned earlier, business expenses other than CoGS can include:
- Salaries and wages
- Rent
- Utilities
- Advertising and marketing costs
- Equipment and other supplies
- Other overheads like legal and accounting fees
- Interest
- Taxes – income tax, payroll tax (minus any applicable tax deductions, of course)
Now, to calculate net income, we use this formula:
GROSS INCOME – EXPENSES = NET INCOME
What are Retained Earnings?
Retained earnings is the amount left over after subtracting dividends paid out to shareholders. As the name suggests, “retained” earnings is the amount that the company keeps after you make all the proper distributions to investors. Retained earnings are accumulated net earnings recorded on the balance sheet under shareholders’ equity.
Dividends are an amount (usually cash) given to investors. These are based on how many shares they own in the company. Dividends are not mandatory payments. However, some note a few reasons why companies suspend dividends. The main reason is that if a company were to pay dividends, that company might undergo financial strain or suffer large debt.
In comparing retained earnings vs net income in terms of gauging financial health, you’ll notice they are quite similar. Because they are both technically profits, a higher value of either one means your company is generally doing very well.
How to Calculate Retained Earnings
Retained earnings are cumulative amounts. This means they increase in value by successive additions done at set periods. These are usually reporting periods (quarterly and annually).
The retained earning formula looks like this:
BEGINNING PERIOD RETAINED EARNINGS + NET PROFIT OF THE PERIOD – DIVIDEND DEDUCTIONS = RETAINED EARNINGS
If you are calculating retained earnings for the first time, the value for the “Beginning Period Retained Earnings” is 0. The amount after calculation then becomes your next beginning amount for the next reporting period.
What’s the Difference Between Retained Earnings and Net Income?
As you can see, net income and retained earnings have a couple of similarities:
- Both are affected by fluctuations in business sales and expenses.
- Both indicate financial health.
However, they also have some differences.
Financial Statements
When thinking about net income vs retained earnings, you may have some questions. For instance, “If you calculate retained earnings after net income, why do you not refer to retained earnings as the “bottom line”?” This is a great question!
A bookkeeper would record net income and retained earnings in different places. Net income goes on the income statement and retained earnings usually go on a balance sheet in the shareholders’ equity section. Retained earnings also have their own financial statement, known as the statement of retained earnings.
Reporting Periods
Most established businesses do quarterly or annual financial reporting. A lot of startups and small companies prefer to do this monthly. This includes preparing monthly income statements. However, you would typically prepare a statement of retained earnings only quarterly or annually.
Necessity
While all companies report their net income, not all companies have shareholders. Naturally, this means that they don’t have to calculate retained earnings.
Types of Earnings
Aside from retained earnings, other earning types include:
Earnings per Share
Earnings per Share (EPS) is a metric that calculates the profitability of a company or the value of a stock per share. To calculate EPS, you need to know your net income, common stock, preferred stock and preferred dividends, and outstanding shares. Most investors typically consider a higher EPS to be a good sign.
- Common stock – an asset or security that is tradeable on public exchanges and shows you have a level of ownership in a company
- Preferred stock – another type of stock that has higher dividend payouts than common stock and higher priority in terms of claiming assets. Preferred dividends are paid out to these types of stockholders, which are often on a set schedule.
- Outstanding shares – these are essentially the stock held by shareholders or the number of issued shares
The price-to-earnings ratio and earnings yield are both calculations that use EPS to determine overall company value and share value over a period, respectively.
EBITDA, EBIT, and EBT
EBITDA refers to Earnings Before Interest, Taxes, Depreciation, and Amortization. In simple terms, EBITDA is taking all expenses and adding them to your net income. EBITDA and revenue are different. Revenue doesn’t account for any expenses. EBITDA calculations do not include operating costs.
EBIT is essentially the same as EBITDA except it takes depreciation and amortization into account. EBIT usually means the same as operating income. This is because it shows you the normal operating costs of a business without applying taxes or interests from loans and such.
EBT, as you may have guessed, only leaves out tax expenses and doesn’t account for applicable tax benefits and deductions.
Types of Income
Gross
Gross income, as we mentioned, is income earned after you deduct the cost of production from your revenue. At this point, this type of income is not yet taxed.
Net
Net income is taxed income after you deduct all other expenses. Some consider this type of income to be the “true” profit of a company.
Investment
Investment income is money earned through investments.
Why Do Retained Earnings and Net Income Matter?
What is the significance of comparing net income vs retained earnings? What value do they provide individually?
Well, net income is an important metric. It is one of the main things you need to calculate retained earnings.
Remember, retained earnings show if you are a worthwhile investment. Think of it as a kind of social proof for investors. By seeing reports of how much your company has grown due to investments, they may be more likely to invest themselves.
Now, net income shows investors if your company is profitable and stable on top of whether it is a potentially good investment.
Both the income statement and statement of retained earnings can indicate your book value, or the value of your assets as a company. The value of these earnings also shows the ability of a company to fund additional growth, pay dividends, and remain financially stable.
Is Revenue More Important than Retained Earnings?
Revenue is considered the “top line” on an income statement because it represents all money earned without subtracting any costs at all. Revenue can indicate demand but doesn’t really show much else. Impressive-looking revenue stats on paper mean nothing if your expenses outweigh them.
This is why retained earnings, though not technically “bottom line” yields the bottom line benefit. Its value overshadows revenue because it shows you how one manages profits and expenses regardless of how much product is being sold. It indirectly shows whether a company is implementing effective pricing strategies, tracking and reducing expenses, optimizing logistics, etc.
Frequently Asked Questions
Which should be higher when comparing retained earnings vs net income?
It’s not unusual for your net income to be higher than your retained earnings after paying out dividends. This is especially true if it’s your first time calculating retained earnings. However, in a situation where you have not paid dividends, your retained earnings can appear to be higher.
Does retained earnings mean net income?
You could call retained earnings “net income after deducting dividends”. However, though they are similar, officially they are defined separately.
How does net income flow to retained earnings?
Retained earnings rely on net income to be calculated. Dividends are subtracted from net income in order to get your retained earnings amount.
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Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
- Monthly Finance Meeting Agenda
- 9 Steps to Master Your Ecommerce Bookkeeping Checklist
- The Ultimate Guide on Finding an Ecommerce Virtual Bookkeeping Service
- What Is a Profit and Loss Statement?
- How to Read & Interpret a Cash Flow Statement
- How to Read a Balance Sheet & Truly Understand It
Conclusion
Comparing net income vs retained earnings can be confusing at first because they have similar benefits. Though they are separate terms that shouldn’t be confused, they do work in tandem. All businesses use net income to assess the bottom line or profitability of their company. Retained earnings apply to companies that have shareholders. Companies pay out dividends to these shareholders. The amount paid out through these dividends is partially determined by the value of the net income. We hope that this post has helped clarify the similarities and differences for you.
