Retained Earnings on the Balance Sheet
When a company generates a profit, management has one of two choices: They can either pay the money out to shareholders as a cash dividend or retain the earnings to reinvest in the business.
That reinvestment may be used to fund acquisitions, build new factories, increase inventory levels, establish larger cash reserves, reduce long-term debt, hire more employees, start a new division, research and develop new products, buy common stock in other businesses, purchase equipment to increase productivity, or a host of other potential uses.
Retained Earnings vs. Dividends
When company executives decide that earnings should be retained rather than paid out to shareholders, they need to account for them on the balance sheet under shareholders' equity. This allows investors to see how much money has been put into the business over the years.
When doing company financial analysis, you can use the retained earnings figure to decide how wisely management deploys and invests the shareholders' money. If you notice a company plows all of its earnings back into itself, yet isn't experiencing exceptionally high growth, the stockholders might be better served if the board of directors declared a dividend instead.
Ultimately, the goal of successful business management is to create $1 in market value for every $1 of retained earnings. Any business that keeps the profit that belongs to you, as an owner and shareholder, without ever sending funds to you in the form of a dividend or increasing your wealth through higher capital gains, does not make for a good investment choice.
Investing relies on putting out money today for more money in the future. It makes no sense to continue holding shares in a corporation that never permits any of the rewards to flow through to its stockholders.
Real-World Retained Earnings Examples
Take a look at an example of retained earnings on the balance sheet:
- Microsoft has retained $18.9 billion in earnings over the years. It has over 2.5 times that amount in stockholders’ equity ($47.29 billion), no debt, and earned over 12.57 percent on its equity the previous year. The company is using the shareholder's money very effectively. With a market capitalization of $314 billion, the software giant has done a very good job.
- Lear Corporation creates automotive interiors and electrical components for everyone from General Motors to BWM. In 2001, the company had retained over $1 billion in earnings and had a tangible asset value of negative $1.67 billion. It had a return on equity of 2.16 percent, which, at the time, was less than a passbook savings account paid. The company was astronomically priced at 79.01 times earnings and had a market cap of $2.67 billion. In other words, shareholders effectively reinvested a billion dollars of their money back into the company in the form of retained earnings, and what did they receive in return? They owed $1.67 billion. That’s a bad investment.
A Deeper Look at Lear
The Lear example deserves a closer look. You may be wondering how the company had a supposed book value of $23.77 per share, and yet the shareholders owed a billion and a half dollars.
If you were to look at Lear's balance sheet, you would notice that it showed shareholders' equity of $1.6 billion and tangible assets of $-1.665 billion. This doesn't seem so horrible until you discover that $3.27 billion of the assets on the company's balance sheet consisted of an intangible asset, goodwill. The shareholders' equity was being inflated by the goodwill figure, and without it, the shareholders were left owing money to the company's creditors
It is immediately apparent that shareholders would have been better off had the company paid out its earnings as dividends. Unfortunately, the economics of the company were so bad that, had the profits been paid out, the business probably would have gone bankrupt.
The earnings were reinvested at a sub-par rate of return. At the time, an investor would have earned more on the earnings by putting them in a CD or money market fund than by reinvesting them into the business.