Businesses have to deal with a chuck financial management to work properly and deliver the intended outcome. You can also check out our accounting service in this concern. This management includes various concepts some of which are highly confusing such as net profit and retained earnings. While they are confusing, they are highly significant due to their roles in financial management.
This article will look into these concepts and provide a good understanding for the readers.
What is the Primary Functioning of Businesses in Their Relationship with These Terms?
A business is simply a structure that operates on the principle of preparing and selling some services or products. This includes processing through different means, labor forces, tools, and facilities. All of these costs and adds to the price or rate of the services or products. Also, certain legal obligations can be part of the cost game such as tax. Next, the services or products are sold over some margin.
Simply put, the selling amount includes both the cost and the margin. This margin is called the profit. This exists in two forms one being called the net profit and the other being called gross profit.
If only the manufacturing cost is considered and deducted from the selling amount then it is gross profit. While if the rest too is deducted then it is called net profit. Both of these contribute to generating the income statement for the business.
Next, the shareholders are paid their shares called dividends. This share is spared from the net profit. After this payment, what is left is called the retained earnings that only belong to the business and are often invested back in the growth of the business.
Their Roles in the Business
Both concepts relate to the financial part of the business. One way or another they play vital roles in the businesses and their growth. To understand these concepts, we need to get to know them in depth:
This is the leftover amount after subtracting all the costs from the revenue amount or sale amount. During the preparation stages, a thing goes through set or sets of activities to prepare a product. All of these generate costs in various shapes and forms. These can be rent, payments for utilities, office supplies, loan interest, repairs, marketing, legal fees, taxes, and others. All of these costs are recorded and later used to calculate net profit.
Next is the revenue. This is the amount received against the sale of the product. Businesses price the product accordingly to all the costs they bear. Every cost is put to the final price and at the same time, a margin is maintained.
This margin is the net profit.
Businesses have investments that make it work. Individuals, groups, and organizations make these investments for the purpose of income; which is often passive in nature. These individuals, groups, and organizations are called shareholders and their income stands as dividends.
These are their share in the earnings or income of the businesses. They are paid out of the net profits that the businesses make after some set period of time. These can be in any form such as cash, debiting, and even reinvestment programs. The amount left after paying them is called the retained earnings.
These are recorded in either the standalone reports or the balance sheet.
How to Calculate Them?
Both Net Profit and Retained Earnings are very important for the working of the businesses. Therefore, they need to be calculated in the most accurate manner possible. You can contact us to get this details. This includes
Net Profit Calculation
Calculating it is very easy. For this, businesses and in a real sense hired accountants need these details:
- Cost of every utility
- Rent of the facility or plant
- Every employee and laborer’s salary
- Supplies for office and units
- Any loans and their payments
- Needed repair work
- Marketing cost
- Transportation cost
- Legal fees and expenditure
- Local, state, and other taxes
- Money depreciation
- Revenue of the project
All of them except the last one provides for the cost as the first variable while the last information stands as the other. It is used to calculate net profit.
Revenue – Total Cost = Net Profit
Retained Earnings Calculation
On the other hand, retained earnings are easier to calculate if dividends are just handed over to the shareholders. In this, details include:
- Earnings from the preceding reporting period
- Net Profit
It is calculated through:
Earning Previous Period + Net Profit – Dividends = Retained Earnings
While this is the primary formula, the actual calculation depends upon the nature of dividends for the shareholders.
- It can be in the case some asset is sold to some shareholder rather than paying the actual amount
- Also, it can be if the dividend is reinvested in the business
- This can get even more complex if a portion is given and a portion is reinvested
- And other conditions
Similarly, in the case of retained earnings, two terms need special understanding. These are:
This is a condition if net income is positive but the retained earning is negative. This happens if dividends exceed the net profit. The company is making a profit as per its sale but the profit can bear the amount paid to the shareholders.
The best way to avoid such a situation is to monitor the net income and retained earnings to make a plan for the future.
While this is the condition where expense exceeds the revenue. In other words, this is where net income is negative. This can be due to various reasons such as:
- Increase in cost of supplies
- Increase in rents
- Seasonal patterns
- And others
In these conditions, retained earnings are in abnormal condition and carry worry for the business.
Financial matters hold a central role in the working of businesses. They need the right management. This includes different important concepts such as net profit and retained earnings. These play a vital role in financial matters. These concepts with their functions and calculations are discussed in the article.