Net income is the profit your business earns during a specific period. Retained earnings are what your business has kept from all its earnings across its entire life, after paying out any distributions to owners.
That’s the main difference. Net income tells you how your business performed during a certain period, while retained earnings show the total profits you’ve kept over time.
How these two numbers work together is important to know. When they’re recorded incorrectly, you will have retained earnings that don’t match, balance sheets that won’t balance, and business owners or board members making decisions based on inaccurate financial reports.
In this guide, you’ll learn what net income vs retained earnings mean, how they’re connected, the formula used to calculate retained earnings, how net income moves into retained earnings at the end of the year, and what all of this means for a small business.
What Is Net Income?
Net income, also called net profit or net earnings, is the amount left after you subtract all business expenses from your revenue for a specific period. This includes the cost of goods sold, payroll, rent, marketing, loan interest, taxes, and other business expenses.
It sits on the last line of the income statement, which is why everyone calls it the bottom line. A positive number means your business made a profit. A negative number means it had a net loss.
Net income only covers one period. It resets with every month, quarter, or year. For example, January’s net income only tells you how the business performed in January.
What Is Retained Earnings?
Retained earnings is the total profit your business has kept since the day it started, minus every dividend or distribution ever paid to owners or shareholders. You’ll also hear it called “accumulated earnings” or “earnings surplus.”
Unlike net income, retained earnings don’t reset each period. They build over time. Every profitable year increases the balance, while losses and owner distributions reduce it. That balance becomes the starting point for the next year.
One thing many owners get wrong is that retained earnings are not the same as cash. They simply show how much profit has stayed in the business. That money may already be invested in equipment, inventory, or paying down debt. For example, a business can have $200,000 in retained earnings but only $9,000 in its bank account, and that’s completely normal.
Net Income vs Retained Earnings: The Key Differences
Here’s the comparison:
They’re different, but they’re closely connected. At the end of each accounting period, net income (or net loss) is added to retained earnings. Net income is the amount earned during the period, while retained earnings are the total that has accumulated over time.
How to Calculate Retained Earnings (The Formula)
The retained earnings formula is:
Retained Earnings = Beginning Retained Earnings + Net Income − Dividends
Beginning retained earnings is simply the ending balance from your last period’s balance sheet. Net income comes from the current income statement, and dividends are whatever was distributed to owners during the period.
Here’s a simple example. A small HVAC company starts the year with $85,000 in retained earnings. During the year, it earns $60,000 in net income and pays the two owners $25,000 in distributions:
$85,000 + $60,000 − $25,000 = $120,000 ending retained earnings
If the same company had a $15,000 net loss instead, the calculation changes: $85,000 − $15,000 − $25,000 = $45,000. Both net losses and owner distributions reduce retained earnings.
Your accounting method affects net income, which also affects retained earnings. Under the accrual method, revenue is recorded when it’s earned. Under the cash basis method, it’s recorded when the money is received. That difference changes how much net income flows into retained earnings each year. We explain this in more detail in our guide on accrual vs cash accounting.
How Net Income Becomes Retained Earnings (The Closing Entry)
This is the part that answers the question people ask: how does the number get from one statement to the other?
The answer is the year-end closing process. At the end of each fiscal year, your revenue and expense accounts are reset to zero so the new year starts fresh, and their net result (the year’s net income) is transferred into retained earnings.
For a profitable year, the closing entry looks like this:
Income Summary
Retained Earnings (for the amount of net income)
If the business reports a net loss, it reverses, and retained earnings is debited.
If you use professional QuickBooks setup services or similar software, you never see this entry happen. The software closes the year automatically on the first day of your new fiscal year, which is exactly why a “Retained Earnings” account appears in your chart of accounts that nobody created on purpose.
We verify this step at every year-end close for clients, because when prior-year transactions get edited after the close, the retained earnings balance changes. Even a small change can affect the retained earnings balance and cause your opening balance to no longer match last year’s tax return. It’s one of the most common issues we find during bookkeeping cleanups.
Where Each One Shows Up on Your Financial Statements
One question we hear a lot is, “Is net income on the balance sheet?” Not as a separate line.
This is where net income appears. You’ll find it on the bottom line.
Retained earnings appear in the equity section. Net income only appears here indirectly, included in the retained earnings balance (and in current-year reports, software shows it as a “Net Income” line inside equity before the year closes).
Some businesses prepare this short report showing beginning balance plus net income minus dividends, equals ending balance.
Each financial statement answers a different question. The income statement shows how your business performed during a specific period, while the balance sheet shows your overall financial position at a particular point in time. We explain the difference in more detail in our guide on the balance sheet vs profit and loss statement, and the SEC’s beginner’s guide to financial statements is a good overview of how all the reports connect.
How Dividends Fit In
Dividends and owner distributions reduce retained earnings. They do not reduce net income, and they are not recorded as business expenses.
This surprises many business owners. For example, paying $25,000 in dividends doesn’t reduce your net income or lower your taxable business profit. Instead, it directly reduces retained earnings.
That’s why a company can report a healthy profit for the year but still end up with lower retained earnings if it paid out more to owners than it earned.
The IRS‘s guidance on dividends covers how distributions are treated on the receiving end.
For small businesses, the same logic applies to owner draws in an LLC or sole proprietorship. A draw reduces the owner’s equity, not business expenses. Recording owner draws as expenses is one of the bookkeeping mistakes our financial advisory team correct, and it makes the business appear less profitable than it really is.
Can Retained Earnings Be Negative?
Yes, they can. Negative retained earnings don’t mean the business is in debt. They simply mean the company has had more total losses and owner distributions than total profits since it started. Accountants call this an accumulated deficit, and it can exist in a business with zero debt.
A business can have negative retained earnings and no loans at all, while another business can have positive retained earnings but still owe a large amount of debt. That’s because debt appears under liabilities, while retained earnings are part of equity. They measure two different things.
A company can earn a positive net income this year and still show negative retained earnings if past losses were large enough. We cover how losses work and what they mean for taxes in our guide on can net income be negative.
What Retained Earnings Means for a Small Business (LLCs and Sole Props)
If you run an LLC or sole proprietorship, your books follow the same idea but may use different terms, such as owner’s equity, member’s equity, or owner’s capital. At the end of the year, your business profit moves into equity, and any owner draws reduce that balance.
QuickBooks still creates a Retained Earnings account and closes your net income into it automatically each year, even for a single-member LLC.
For small business owners, the most important thing to understand is that this balance shows your business’s financial history.
The U.S. Small Business Administration places accurate statements at the center of managing business finances, and retained earnings is often the first thing a loan officer checks because it helps them see if the business has consistently earned more than the owner has withdrawn.
Keep Both Numbers Accurate
Net income shows how your business performed during a specific period. Retained earnings show what the business has kept. Both numbers matter, but only if they’re accurate.
In my 6+ years working with US small businesses, retained earnings is where bookkeeping errors hide. Owner draws get recorded as expenses, previous-year transactions get changed after the books are closed, or distributions never get recorded at all. The income statement may look fine while the equity section quietly becomes inaccurate.
If your retained earnings don’t match your prior-year tax return, or you’re not sure what’s inside that balance, our professional bookkeeping team can reconcile it. We can trace the balance back to its source, correct any errors, and make sure your financial statements are accurate and ready for your CPA or lender.
Book a free consultation, and we’ll take a look at your equity section together. By the end of the call, you’ll know if anything needs to be fixed.
FAQ’s
How do you go from net income to retained earnings?
Add net income to the beginning retained earnings balance, then subtract any dividends or owner distributions. Software like QuickBooks records this automatically at the start of each new fiscal year.
Is retained earnings on the income statement or the balance sheet?
Retained earnings appear on the balance sheet under the equity section. Net income appears at the bottom of the income statement and is later transferred into retained earnings.
Can retained earnings be higher than net income?
Yes, for an established business. Retained earnings builds up over many years, so it's often several times larger than any single year's net income.
Do dividends come out of net income or retained earnings?
Dividends and owner draws come out of retained earnings. They aren't business expenses, so they don't reduce net income, but they directly reduce the equity balance.
Muhammad Aaqib is the founder of Predawn Accounting and has more than six years of experience helping small businesses maintain organized financial records, improve reporting accuracy, and better understand their financial position. He is a qualified Chartered Accountant from ICAP Pakistan, holds a BS in Accounting and Finance, is an ACCA Candidate, an FMVA Certified professional, has also earned a Financial Planning and Analysis certification from the Corporate Finance Institute (CFI), and is a certified QuickBooks ProAdvisor with experience working across industries, including real estate, construction, e-commerce, SaaS, and marketing agencies.
Before founding Predawn Accounting in 2023, Mr. Aaqib worked with businesses across multiple industries, doing bookkeeping, financial reporting, financial modelling, fractional CFO, and other projects. He has also completed financial projects that helped businesses raise funding and improve financial operations.
