Companies need to carefully track their retained earnings because this measure is one of the most important to track. Retained earnings represent an important linkage between the profit and balance sheet, as they’re reflected under retained assets, which links the two statements together. The purpose of keeping these earnings is diverse and comprises of purchasing new machinery and software, spending on marketing and promotion, or any other actions that might potentially generate future growth for the organization. Understanding how to best measure retained earnings presents significant challenges to management teams, particularly since many companies have little experience with or rely on this measure.
Most businesses track retained earnings in different ways. A common practice is to provide a line item of revenue from new and existing customers, along with an operating and maintenance segment on the statement of earnings. Other measures often used are calculating EBIT (earnings before interest, taxes, depreciation, and amortization), or providing a gross profit margin. While these practices are helpful for overall assessment of performance, they do not provide a holistic view of the company’s profitability and often fail to take into account key areas such as the inventory and service mix. This means that companies can confuse retained earnings with net income or profit and loss, another important but misunderstood measure. In order to get a full picture of a company’s profit and cash flow, including retained earnings, it’s important for managers to understand the relationship between this line item and the balance sheet and report all relevant information accordingly.
To illustrate, if a company reports gross profit of $40 million and reports a net income of only $30 million, a large part of the difference is attributable to the difference in EBIT (earnings before interest, taxes, depreciation, and amortization). To make matters worse, when measuring financial performance measures, companies frequently fail to adjust for the effect of changing market prices, which can skew reported income results. In addition, because most of the reporting requirements for corporations are now based on Net Income diluted to net income, companies are required to calculate their reported diluted earnings per share using specific definition and standards. To avoid such complexities, it’s important for management to track key performance indicators such as gross and net profit and focus on those areas only. A CFO can also help create a more accurate picture of a company’s liquidity and creditworthiness by providing regular reports on cash flow and debt and equity financing programs.