What it means
Retained earnings are the profits a company has kept over its lifetime instead of paying out as dividends. When the running total is positive, it increases equity, but when losses have outweighed profits, the total turns negative and is called an accumulated deficit.
It is a cumulative figure, not a measure of a single year. Accumulated deficits are very common among start-ups and growth companies.
A business may spend heavily on product development, hiring and marketing for years before sales cover those costs. The deficit grows with each loss-making year and shrinks only when the company makes profits that outweigh it.
An accumulated deficit does not mean the company is bankrupt, or that it has no cash. It is an accounting record of past performance, and many companies with large deficits are well funded by investors.
What matters is whether the company can eventually turn profitable or keep raising money to fund its losses. Still, a large deficit can reduce total equity or even make it negative, which is a warning sign to lenders and investors.
It may limit the company's ability to pay dividends, because laws in many places restrict distributions when there are no accumulated profits. It can also affect loan covenants that require minimum levels of equity.
When reading a balance sheet, look at the trend. A deficit that is growing more slowly each year suggests the business is getting closer to profitability.
A deficit that is accelerating signals that losses are increasing and funding needs will rise. Investors often judge a deficit alongside the company's cash runway, which is how many months it can operate before running out of money.
A company with a large deficit and 30 months of runway is in a very different position from one with the same deficit and 3 months. Reading the two together is far more informative than reading either alone.
In practice
Real-world examples
Example 1
A cloud software start-up has lost money every year while building its product. After four years its accumulated deficit is $9,000,000, funded by investor capital. The founders point to rapid revenue growth as evidence that the deficit will shrink, and investors track the quarterly losses to test that claim.
Example 2
A restaurant group closes three underperforming branches and records large write-offs. Its accumulated deficit climbs to $1,200,000. Subsequent profits from the remaining branches gradually reduce it.
Example 3
A manufacturer returns to profit after a long downturn. Its $2,500,000 accumulated deficit falls to $1,900,000 after a $600,000 profit year. Under the company law of many countries the board cannot pay a dividend until the deficit has been cleared, so shareholders must wait.
Think of it
Think of an accumulated deficit like a household running a deficit on its credit card over many years. Even if you manage to balance your budget this month, the historical debt from previous years stays on your statement as a running total until you pay it off.
Formula
Calculation
Closing retained earnings = Opening retained earnings + Net income - Dividends
A company starts the year with an accumulated deficit of $400,000, which is retained earnings of -$400,000. It loses $150,000 during the year and pays no dividends. Closing retained earnings = -$400,000 + (-$150,000) - $0 = -$550,000. The accumulated deficit at year end is therefore $550,000.Case study
Seen in the real world
Tidewater Biotech is a fictional research company that, in this illustrative story, spent six years developing a diagnostic test with no sales. By the end of that period, its accumulated deficit reached $14,000,000, and total equity was close to zero because investors' capital had been spent.
The directors approached a bank for a working capital loan. The bank noticed the large deficit but also saw signed purchase orders from three hospital groups and a clear path to $5,000,000 of annual revenue.
The bank agreed to lend, with a covenant requiring the company to maintain a minimum cash balance. As revenue grew, losses narrowed from $2,000,000 to $1,000,000 over two years, and the accumulated deficit reached $17,000,000 before profits began to reduce it.
Watch out
Common mistakes
- Assuming an accumulated deficit means the company has no cash. The deficit is a record of past losses, not the current bank balance.
- Reading it as the loss for the year. It is the sum of all past profits and losses since inception.
- Assuming a deficit means the company will fail. Many successful businesses carried large deficits while they grew.
Questions
People also ask
Is accumulated deficit the same as retained earnings?
It is retained earnings when the figure is negative. Positive figures are called retained earnings and negative ones accumulated deficit.
Where does it appear on the balance sheet?
It is shown in the equity section, usually as a negative line below share capital. It reduces total shareholders' equity.
How can a company reduce its accumulated deficit?
By earning profits that exceed the deficit over time, or, in some places, through a formal capital restructuring approved by shareholders and the courts. Raising new capital does not reduce the deficit but does strengthen equity.