The cash flow statement is an important analysis tool for small businesses that use the accrual accounting method. In this method, companies book sales when they are earned and costs when they are incurred. This creates a cash timing differential influenced by when cash flows into and out of a company. The cash flow statement charts these cash flows. Retained earnings do not appear as retained earnings on the cash flow statement. Increases appear as profits.
Retained Earnings
Retained earnings are the earnings, or profits, that a company retains to support growth, strengthen its financial position or save for future use. Retained earnings are accumulated profits from prior period income statements. Owner withdrawals or distributions reduce retained earnings as do net losses. Retained earnings appear on the balance sheet as a component of owner's equity. Profits in one period flow through the operating section of the cash flow statement on their way to the balance sheet in the next period. Therefore, increases to retained earnings flow through the operating section. However, these increases are called "net income" -- not "retained earnings" -- on the cash flow statement.
Owner Equity
The balance sheet equation is assets plus liabilities equal owners equity or net worth. Net worth includes start-up capital injections, additional capital infusions and retained earnings minus any distributions. Owner equity adjustments typically impact retained earnings unless the owners contribute more equity capital or obtain capital from investors.
Increase in Retained Earnings
The financing section of the cash flow statement captures the cash flows related to financing, which include activities involving liabilities and owner equity. This includes the infusion of additional equity and the attainment of new loans, both of which increase financing cash flow. This also includes the payment of loan principal and distributions to owners, both of which decrease financing cash flow. No increases to retained earnings appear in this section because only profit increases cash flow and profit is an operating item. However, decreases to retained earnings -- dividends and distributions -- do appear in the financing section.
Example
Assume that a company's income statement shows a net income of $100,000 for the year as of Dec. 31. Its cash flow statement shows net income of $100,000 plus cash and noncash adjustments to operational cash flow, and the owners have taken no distributions. On Jan. 1, the balance sheet will show an increase of $100,000 in retained earnings.