The Number That Decides Your Dividend
Most directors of a small limited company glance at retained earnings once a year, see a figure on the bottom of the balance sheet, and move on. Then they take a dividend, and only later discover that the figure they ignored is the one that decided whether that dividend was even legal.
Retained earnings are not an accounting footnote. They are the running total of every pound of profit your company has ever kept, and under UK company law they set the ceiling on how much you can pay yourself in dividends. Get the figure wrong and a dividend can be unlawful, repayable, and a problem at your next set of accounts.
This guide explains what retained earnings are in plain English, gives you the formula, walks through a worked example, and clears up the two things people most often get wrong: that retained earnings are cash, and that they are an asset. Neither is true, and the difference matters.
What Retained Earnings Actually Are
Retained earnings are the cumulative profits a company has earned since it started trading, less every dividend it has ever paid out and less corporation tax. They are the part of profit the business has chosen to keep rather than distribute.
Every year your company makes a profit after tax. Some, or all, of that profit can be paid out to shareholders as dividends. Whatever is left over is "retained" and added to the pile from previous years. That growing pile is your retained earnings, and it sits in the equity section of your balance sheet under a line often labelled "retained earnings", "profit and loss reserve", or "distributable reserves".
The key word is cumulative. Retained earnings are not this year's profit. They are the sum of every year's kept profit since incorporation. A company ten years old will have ten years of retained profit stacked up in that one figure, minus everything it has ever distributed. This is why the line can be large even in a year the business barely broke even, and why it can be small in a great year if the owners took most of the profit out.
Retained Earnings Are Not an Asset, and Not Cash
This is the misunderstanding we correct most often, so it is worth being blunt about it.
Retained earnings live in the equity section of the balance sheet, alongside share capital. They are not an asset. An asset is something the company owns, like cash, stock, or a van. Retained earnings sit on the other side of the balance sheet entirely. They are a measure of how much of the company's assets have been funded by profits the owners left in, rather than by share capital or borrowing. So when someone asks "is retained earnings an asset?", the answer is a flat no. It is part of equity.
They are also not cash. This trips up almost every first-time director. A company can show £80,000 of retained earnings and have £3,000 in the bank, because over the years that retained profit was spent on fixed assets, tied up in stock, or sitting in unpaid trade receivables. The profit was real and it was kept, but it was reinvested, not left as cash. As we explain in our working capital guide, profit and cash drift apart constantly, and retained earnings is the accumulated version of that drift. The figure tells you how much profit has been retained, not how much money you have to spend.
The Retained Earnings Formula
The formula is simple, and once you have seen it the figure stops being mysterious:
Closing retained earnings = Opening retained earnings + Net profit after tax − Dividends paid
That is it. You start with the retained earnings brought forward from last year, add this year's net profit after corporation tax, and subtract any dividends paid during the year. The result carries forward to next year as the new opening figure, and the cycle repeats.
The same logic explains how retained earnings can fall. If you pay out more in dividends than you made in profit, or if the company makes a loss, the closing figure goes down. There is nothing wrong with that in a single year, but if it keeps happening the reserve eventually runs out, and that is where the legal problems start.
A Worked Example
Take a small consultancy company at the start of its financial year.
- Opening retained earnings (brought forward): £45,000
- Net profit for the year after corporation tax: £30,000
- Dividends paid to the director-shareholder during the year: £20,000
Putting those into the formula:
£45,000 + £30,000 − £20,000 = £55,000
So the company ends the year with £55,000 of retained earnings, which becomes next year's opening figure. The business made £30,000, kept £10,000 of it, and added that to the £45,000 already there.
Now change one number. Suppose the same company had a poor year and made only £8,000 profit, but the director still took a £20,000 dividend out of habit. The formula gives £45,000 + £8,000 − £20,000 = £33,000. The reserve fell by £12,000, because the owner distributed £12,000 more than the company earned that year. The dividend was still legal, because there was £53,000 of reserve to draw on before paying it, but do that for a few years running and the cushion disappears.
Why Retained Earnings Govern Your Dividends
Here is the part that turns retained earnings from a passive figure into something every director needs to watch.
Under the Companies Act 2006, a company can only pay a dividend out of "profits available for distribution", which in practice means its accumulated realised profits, less accumulated realised losses. That is, essentially, the retained earnings figure. If a company pays a dividend when it does not have enough distributable reserves to cover it, the dividend is unlawful. A director who knew, or ought to have known, there were insufficient reserves can be required to repay it personally.
This is not a theoretical risk for small companies. It is one of the most common problems we see. An owner-director takes regular monthly dividends through the year, the year turns out worse than expected, and the dividends paid exceed the available reserves. The shortfall becomes an illegal dividend, which HMRC may then treat as a director's loan or as salary, with tax consequences attached. The reserve, the very figure people skip over, was the legal limit all along.
The practical lesson: before you take a dividend, check that the company has enough retained earnings to cover it, and that it has the cash to pay it without choking the business. Those are two separate tests, because, as we have said, retained earnings are not cash.
Negative Retained Earnings
If a company's accumulated losses exceed its accumulated profits, retained earnings go negative. On the balance sheet this is often shown in brackets and called an accumulated deficit.
A negative figure is not automatically a crisis. A young company that has invested heavily, or a business recovering from one bad year, can carry a deficit and trade out of it perfectly well. What it does mean is that the company has no distributable reserves, so it legally cannot pay a dividend until it has earned enough new profit to bring the figure back above zero. For an owner who takes income mainly as dividends, that is a hard constraint, and it usually means switching to salary, which our director's remuneration guide covers in more detail.
Persistent and growing negative retained earnings are a different matter. They signal a business that is consuming the capital its owners put in, and at some point that raises questions about whether the company can continue. That is where the figure stops being an accounting line and becomes a warning.
Our View: Treat It as a Ceiling, Not a Trophy
In our experience, directors fall into two camps with retained earnings, and both miss the point.
The first camp treats a large retained earnings figure as a trophy, proof the business is doing well, and assumes the money is there to spend. It often is not, because it was reinvested years ago. The second camp ignores the figure entirely and takes dividends on autopilot, only to find at year end that they overdrew the reserve.
The right way to think about retained earnings is as a ceiling. It is the legal maximum you can distribute, and it should be checked, with up to date figures, before any dividend, not reconstructed after the fact when the accounts are prepared. Pair that check with a look at the bank balance and your cash flow, because a dividend needs both legal headroom and actual cash behind it. Run the business that way and retained earnings stop being a number you discover once a year and become a control you use all year.
How IAK Can Help
We keep the figure that governs your dividends accurate and current. Clean bookkeeping records every profit, tax charge and dividend so your reserve is right rather than estimated, management reporting shows you distributable reserves and cash side by side before you draw income, and our accounting work produces a full set of year-end statements where the retained earnings figure ties to everything else and stands up to scrutiny.
If you are not sure how much you can safely take out of your company, that is exactly the conversation retained earnings should drive. Contact us for a straight answer about your numbers.
Sources
- Companies Act 2006, Part 23, sets out the rules on distributions, including that a company may only pay a dividend out of profits available for the purpose. Published on legislation.gov.uk.
- FRS 102, the financial reporting standard for most UK small and medium companies, which sets out how reserves and equity are presented. Published by the Financial Reporting Council.
- GOV.UK guidance on taking money out of a limited company, including dividends and the requirement for sufficient profit.