Management decides how to spend surplus income in a number of ways. Retained earnings shows investors how their profits drive future growth of the business. After all, as part owners of the corporation, shareholders want to see their put to good use.
What Is Retained Earnings?
Retained earnings is an accounting measure showing the amount of net earnings not paid as dividends. Management has various uses of this cash, such as reinvesting in the business through research and development (R&D), or buying new equipment. This number appears on the company balance sheet under shareholder’s equity.
Furthermore, retained earnings are reported each accounting period, and are added to the beginning retained earnings from the period, added to net income, less dividends. This equation shows Retained Earnings = Beginning Retained Earnings + Net Income – Dividends.
What Do Retained Earnings Tell You?
This number is another way of evaluating net income. From the formula, analysts see that net income affects the change in retained earnings. Though the change does not appear directly in financial statements, investors notice how this number changes each period. Also, they notice if the dividend grew, or if management spent capital on future growth.
Additionally, this measure does not infer excess cash earned, but rather labels how management used the net profit. Trends of dividend paying versus reinvestment differ across industry. Furthermore, they differ with maturity of companies. New companies need as much free cash as possible for expansion and liquidity, whereas an industry giant focuses on capital structure and returning money to shareholders.
Finally, it is important to remember that retained earnings is a measure of the company’s cumulative earnings since inception minus dividends. This is not to say it is a measure of the company’s value, but rather how the company uses its surplus profit over time. Savvy investors understand the best management techniques and invest in companies that use their profits to create the most value.