What is the relationship between Net Income and Retained Earnings on the balance sheet?

The relationship between Net Income and Retained Earnings is foundational to understanding how a company's profits are reinvested or distributed. Net Income, which is the profit after all expenses, taxes, and costs have been accounted for, directly influences Retained Earnings, which is a component of shareholders' equity on the balance sheet.

When a company earns Net Income, this figure is added to Retained Earnings from the previous period. However, before this addition occurs, dividends are usually paid out to shareholders. Therefore, the change in Retained Earnings for the period is calculated by taking the current period's Net Income and subtracting any dividends paid. This flow shows how the company's profits after distributions directly enhance or affect Retained Earnings, thus reinforcing the connection between the two.

Understanding this relationship is critical for analyzing a company's financial health and how well it is managing to reinvest profits for growth, maintain competitive advantages, or provide returns to shareholders.