What is retained profit? A guide for small businesses

What is the definition of retained profit?

The definition of retained profit is the profit a business makes that doesn’t need to be paid out as dividends. Retained profits are also known as retained earnings.

Large companies will often pay out a portion of profits (a dividend) to owners and shareholders. Smaller companies may also pay out dividends.

Retained profit goes on your balance sheet in the equity section.

So, what is retained profit exactly?

But does retained profit mean anything for small businesses and sole traders that don’t pay out dividends?

In short, yes. Retained profit is an important concept even for these businesses, as it helps them work out how much profit they can use to finance the business.

If you keep profits in the business, it can mean you don’t have to look for other types of financing, like bank loans or grants.

It can help to think of retained profit in other terms too, for example your business’s earnings surplus or trading profits.

As part of the balance sheet, retained profit helps you understand the health of your business. It goes in the equity section, which you add up with liabilities to equal (or balance with) the total of your business assets.

Retained earnings on balance sheet

As mentioned, retained profit goes on your balance sheet. It builds up over accounting periods, with the net income or loss from a particular period changing the overall figure.

This means it’s not a great indicator of your business’s current success, as it doesn’t show its cash flow position or bank balance.

But as mentioned, it’s an important measure of your business’s overall health. Retained profit can help you decide whether to invest in its growth, and it can attract investors too.

Doing your balance sheet and completing other financial statements (like your profit and loss account, cash flow forecast, and budget) will give you a deep understanding of your business’s position.

What’s the retained profit formula?

Wondering how to calculate retained earnings? When doing your balance sheet, you can use this formula:

Retained profit = opening retained profit + net income or loss – dividends

So you need to know your retained profit from the last accounting period, the net income or loss you made for the current one, and any dividends you want to take (or pay out).

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Retained profit advantages and disadvantages

Having retained profits usually means that your business is in a good position, so there are plenty of advantages to keeping (and reinvesting) money in your business.

Yet there are some downsides too, which we go into here.

Retained profit advantages

• You can grow your business – reinvesting profits into your business will help drive its growth, if that’s your ambition (for example, researching and launching new products)
• You don’t have to get external funding (or borrow money) – you can finance your business yourself, as it can be tough completing applications for loans and grants (or looking for angel investors and venture capital)
• Your business looks better on paper – if you were to look for external funding though, investors or lenders will look to your balance sheet, and retained profit is one sign of a business’s health
• It gives you financial safety – your reserves are drawn from your retained earnings and help pay for balance sheet debts, plus retained profits can cover you for emergencies

Retained profit disadvantages

• You could access external funding quicker – looking for finance elsewhere can help you grow your business quicker in the early stages, rather than waiting until you’re making profit
• External expertise can also help you grow – missing out on external funding means you could miss out on external expertise, in the form of angel investors for example
• Your business needs cash to operate – you need to be sure that building up retained profit means that no other part of your business will suffer

More useful guides for small business owners

• How to write an invoice (and free invoice template)

• How to write a late payment letter

• A guide to bookkeeping for small businesses

• What is business insurance?

Would you like to know more about retained profit? Let us know in the comments below.