Retained Earnings on the Balance Sheet
When a company generates a profit, management can pay out the money to shareholders as a cash dividend or retain the earnings to reinvest in the business.
The reinvestment could go toward any of a number of things that might help the business. It could be used to fund acquisitions, build new factories, increase inventory levels, establish larger cash reserves, reduce long-term debt, hire more employees, research and develop new products, or purchase new equipment to increase productivity.
The company could also choose to buy back its own shares, which might have the long-term benefit of increasing the company's market value. Because there will be fewer shares outstanding, the company's per-share metrics like earnings per share and book value per share could increase and make the company's stock more attractive to shareholders.
Examining Retained Earnings
When company executives decide that earnings should be retained rather than paid out to shareholders as dividends, they need to account for them on the balance sheet under shareholders' equity. When financially analyzing a company, investors can use the retained earnings figure to decide how wisely management deploys the money it isn't distributing to shareholders.
If a company plows all of its earnings back into itself yet isn't experiencing exceptionally high growth in key financial measures, stockholders might be better served if the board of directors declared a dividend instead.
Retained earnings can be a negative number if the company has had a loss or a series of losses that amount to more than its recent profit or series of profits. In this situation, the figure can also be referred to as an accumulated deficit.
A Warren Buffett Test
In 1983, in his first Owner's Manual for Berkshire Hathaway shareholders, Warren Buffett said a test for managers about the wisdom of retaining earnings should be whether they are creating at least $1 in market value for every $1 of retained earnings on a five-year rolling basis.
In the company's 2017 annual report, Buffett revised that test to account for periods when stock market values have dropped significantly during the previous five years, which had sometimes resulted in Berkshire's market-price premium to book value decreasing and the company failing that test: "The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense."
Retained losses can result in negative shareholders' equity; they can be a serious sign of financial trouble for a company or, at the very least, an indication that the company ought to lower its dividend.
A Real-World Retained Earnings Example
Let's take a look at an example of retained earnings on a company's balance sheet and some other financial measures that can indicate whether management has been using the retained earnings effectively.
Apple Inc., a consumer electronics and computer maker and provider of related services, had retained earnings of $45.9 billion as of September 28, 2019, the end of its 2019 fiscal year. It had almost twice that amount in shareholders' equity: $90.5 billion.
Apple's return on equity—an important measure of how effectively a company's management is utilizing company assets to generate profits—was 61.1% as of September 28, 2019. (That figure was obtained by dividing its net income of $55.3 billion by its shareholders' equity of $90.5 billion.)
The company also announced dividends totaling $3.00 a share in that fiscal year and used $14.1 billion in cash to pay dividends or dividend equivalents.
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