Retained earnings (retained profit): what they are and how to calculate them

Short answer: retained earnings (in the UK usually called retained profit, retained profits or the profit and loss reserve) are all the profit a business has made since it started, after tax, minus everything paid out to the owners as dividends or drawings. The formula is closing retained earnings = opening retained earnings + net profit after tax − dividends. They sit in the Equity section of the balance sheet, not in the bank: the profit you kept may be in cash, but it may also be in unpaid invoices, stock, equipment or loan repayments. If they go below zero they are called accumulated losses. In Xero, the balance sheet shows them as two lines, Retained Earnings (earlier years) and Current Year Earnings (this year so far).

The retained earnings formula

Closing retained earnings = opening retained earnings + net profit after tax − dividends (or drawings)

• Opening retained earnings is last year’s closing figure. A new business starts at zero.
• Net profit after tax is the bottom line of the year’s Profit and Loss, after corporation or company tax. A loss is a negative number here.
• Dividends or drawings are what the owners took out of the profit. They are not expenses, so they never appear on the Profit and Loss; they reduce retained earnings directly. How to pay dividends, and record them in Xero shows the check before a UK company pays one.

Salaries paid to a director through payroll are an expense, so they have already been taken off before net profit. Only the payments taken out of the profit count in the last step. Money a director takes that is neither salary nor a declared dividend is a loan from the company, not a payout, and goes on the director’s loan account.

A worked example: three years of a small company

These are made-up figures for a small UK design agency run as a limited company with £100 of share capital. Corporation tax is at the 19% small profits rate (profits over £50,000 pay more; the corporation tax calculator works out any year’s figure).

	Year 1 (£)	Year 2 (£)	Year 3 (£)
Opening retained earnings	0	12,400	6,700
Net profit before tax	40,000	30,000	−10,000
Corporation tax (19%)	−7,600	−5,700	0
Net profit after tax	32,400	24,300	−10,000
Dividends paid	−20,000	−30,000	0
Closing retained earnings	12,400	6,700	−3,300

What each year says:

• Year 1: the company made £32,400 after tax, paid out £20,000 and kept £12,400. That £12,400 is the cushion: the profit the owners have chosen to leave in the business.
• Year 2: profit fell to £24,300 after tax, but the owners took £30,000. They paid out £5,700 more than the company earned that year, so retained earnings fell from £12,400 to £6,700. That is allowed, because the dividend came out of profit kept from year 1, but it cannot go on: two more years like this and the kept profit is gone.
• Year 3: a £10,000 loss takes retained earnings to −£3,300. The company now has accumulated losses. In the UK a company can only pay dividends out of profits available for distribution, so until profit brings the figure back above zero, there is nothing to pay a dividend from. A dividend paid without distributable profits is unlawful and may have to be paid back, so ask your accountant before declaring one. In Australia and New Zealand the dividend rules lean on solvency tests instead, but a negative figure is still the point to ask.

Retained earnings are not cash

Take the agency at the end of year 1. Retained earnings are £12,400, but that does not mean £12,400 is in the bank. Its balance sheet reads:

	£
Bank	9,100
Customers who have not paid yet	8,000
Laptops and screens	3,000
Corporation tax owed to HMRC	−7,600
Net assets	12,500
Share capital	100
Retained earnings	12,400
Equity	12,500

The kept profit is spread across the assets: £8,000 is still in unpaid invoices and £3,000 went on equipment. The bank holds £9,100, but £7,600 of that is corporation tax that is due later, so only about £1,500 is really free. The owner who reads “£12,400 of retained earnings” as “£12,400 I can take out” would empty the account and be short when the tax bill comes. Before taking a dividend, check both: retained earnings say whether there is profit to pay it from, and the bank, less tax and bills due, says whether there is the cash. How much can I pay myself sizes the cash side, and profit in Xero but no cash in the bank explains where profit goes when it is not in the bank. To see how much of a year’s profit actually turned into cash once equipment is paid for, use the free cash flow calculator.

Where to find retained earnings in Xero

Run Reporting › Balance Sheet (Accounting › Reports in Xero’s older menu) for the date you want. In the Equity section Xero shows:

• Retained Earnings: the profit from all earlier financial years that is still in the business.
• Current Year Earnings: this financial year’s profit so far, the same figure as the bottom line of the year-to-date Profit and Loss.

Both are system accounts that Xero fills in itself. At the start of each financial year (set under your organisation’s financial settings), Xero moves the year’s profit from Current Year Earnings into Retained Earnings without a closing journal. So the up-to-date retained earnings figure is Retained Earnings + Current Year Earnings, less any dividends or drawings account that also sits in Equity. Xero only rolls the profit over; a separate dividends or drawings account keeps its own line until your accountant journals it, so read every equity line, not one.

Two things to watch mid-year:

• Current Year Earnings is usually before tax. Company tax is normally posted once at year end, so during the year the figure overstates what will be left after tax.
• Sole traders and partnerships do not have retained earnings in the company sense: the profit belongs to the owners each year whether they take it out or not. Xero still shows the lines, with drawings and funds introduced alongside them.

Menu names move between Xero releases and differ slightly by region; if a label does not match your screen, search Xero Central for the report name. How to read your balance sheet in Xero goes through every other section, and profit and loss vs balance sheet shows how the year’s profit lands in equity.

What the trend tells an owner

• Rising every year: the business makes more than the owners take out. That is what lets it ride out a bad quarter, buy equipment or hire without borrowing.
• Flat: the owners take out about what it earns. Fine for a mature business with a cash buffer; risky if there is none. The cash runway calculator shows how many months the bank would last.
• Falling: payouts are bigger than profit, or there were losses. Check the reason before it reaches zero.
• Negative: accumulated losses. No dividends until it recovers (in the UK), and lenders will ask about it. The tax losses behind them are tracked separately in the tax return and can cut tax once profit returns; see net operating loss.

Compare the figure from one year end to the next, not month to month, because Current Year Earnings moves every time a sale or bill is entered. The Xero annual report guide lists the year-end checks to do before you trust that figure, and the Xero year end checklist shows the adjustments that usually change it. Gross and net profit, which feed it, are explained in gross profit vs net profit.

Common questions

What are retained earnings? Retained earnings are the total profit a business has made since it started, after tax, minus everything paid out to the owners as dividends or drawings. They show how much profit has been kept in the business, and they sit in the equity section of the balance sheet.

How do you calculate retained earnings? Take last year’s closing retained earnings, add this year’s net profit after tax (or subtract a loss), and subtract the dividends or drawings paid this year. For example, 12,400 opening plus 24,300 profit after tax minus 30,000 of dividends gives 6,700 closing retained earnings.

Is retained profit the same as retained earnings? Yes. Retained profit, retained profits, the profit and loss reserve and retained earnings all mean the same thing. UK accounts often say retained profit or profit and loss account (the profit and loss account guide explains the three ways UK accounts use that name); Xero and most Australian and New Zealand accounts say retained earnings.

Are retained earnings an asset? No. Retained earnings are part of equity, which records where the business’s net assets came from. The kept profit is held in the assets themselves: cash, unpaid invoices, stock or equipment. That is why a company can have large retained earnings and very little in the bank.

Can retained earnings be negative? Yes. When losses since the start add up to more than the profits, minus what was paid out, retained earnings are negative and are called accumulated losses. In the UK a company cannot pay dividends until profit brings them back into positive territory, so ask your accountant before paying one.

Where are retained earnings in Xero? On the Balance Sheet, in the Equity section. Retained Earnings holds profit from earlier years and Current Year Earnings holds this year’s profit so far. Xero moves Current Year Earnings into Retained Earnings at the start of each financial year, so add the two together for the current figure.

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