Negative Retained Earnings: Definition, Impacts, and Effects

Written by SmartBiz Team | Sep 17, 2020 4:00:00 AM

Your business’s balance sheet is filled with figures that spell out your business’s financial health. It may be tempting to keep things simple with a final profit or loss amount, but each line item helps you understand how and why your business is making or losing money. One of those figures is called retained earnings if in the black or negative retained earnings if in the red. Here, we’ll focus on what negative retained earnings mean and what they indicate for the success of your business.

What are negative retained earnings?

To understand negative retained earnings, it’s important to define retained earnings. Once your business pays all its taxes, expenses, and other debts owed each period – including your shareholders’ dividends, if applicable -- the money left over is called retained earnings. Funds from retained earnings are often used to reinvest back in the company and fuel future growth, but it’s also important to keep a portion on hand to ensure your business’s long-term financial health.

Retained earnings are calculated with the following formula:

RE = BP + Net Income or Net Loss - C− S

BP = beginning period retained earnings

C = cash dividends

S = stock dividends

This figure can enter the red when accumulated net losses and dividends payouts exceed your previous profits. That figure is called negative retained earnings. Sometimes called retained losses, accumulated deficit, or accumulated losses.

Analyzing negative retained balance on your balance sheet

Consider the below points when analyzing the negative retained balance on your balance sheet:

Is your business cyclical? Some businesses are particularly sensitive to economic upswings and downswings. For example, luxury goods providers like jewelry stores typically perform better during times of prosperity and do not perform well during times of economic hardship. This could partially explain why you’re showing a negative retained balance. On the reverse, many cyclical businesses try to prepare for an economic downturn by keeping more cash on hand for retained earnings.
How old is your company? Retained earnings (and negative retained earnings) are tracked over your company’s lifetime. Older companies have time on their side – the longer your company has been around, the more time to compile retained earnings.
What is your dividend policy? Paying out dividends frequently eats into your retained earnings. If you find that you’re paying out dividends too often to build retained earnings, you may want to reconsider this timeline.
Are you profitable? Your profits add up over time and contribute to your retained earnings. Additionally, time and dividends payouts contribute to this end total.

Seven impacts and effects on negative retained earnings

Negative retained earnings can connotate several facts about the health of your business. If your business is experiencing negative retained earnings, it could indicate any of the following issues:

It opens your business to questions. Particularly if you have investors or shareholders, and especially if you show negative retained earnings for several periods, other parties will want to know why your business is consistently in the red.
It may be a sign of bankruptcy. In some of the worst-case scenarios, negative retained earnings can be an indicator of serious financial trouble down the road. Shareholders, investors, and other stakeholders may be rightfully concerned about your business’s ability to stay afloat.
It can decrease the total number of shareholder’s equity. This negative figure on your financial records guarantees that your shareholders will receive a smaller slice of the pie, as there is simply less pie to share.
It could reflect too-large dividend payouts. Since your shareholder payments take away from your retained earnings, negative retained earnings could indicate that you’re paying out too much in dividends.
It may be a sign that your expenses are too high. This could be due to several factors, including an increase in tax payments, unexpected costs arising throughout the period, or a general increase in spending. It may be time to examine your entire budget and identify areas to slow down or stop spending.
Errors of past years discovered in the reporting period. Retained earnings are tracked throughout the lifetime of a company. If accounting errors were identified in prior periods, they may reflect in your current negative retained earnings.

Negative retained earnings and your business

Although seeing the word “negative” in a business context may draw up feelings of unease, negative retained earnings are not always a bad sign. They are less troubling for young companies with an impressive growth trajectory, a phenomenon common among some of the largest internet and tech companies. However, as time goes on, and you continue to grow and expand, negative retained earnings can be an indicator of your long-term health.

View full post