Why investors pay attention to retained earnings

Monday, October 15, 2018 | MarketBeat Staff
Why investors pay attention to retained earnings

When we make out a personal budget, we quickly learn the difference between our salary, our take-home pay, and our disposable income. We may earn a six-figure salary, but once taxes are taken out, along with health insurance and other deductions (e.g. an automatic 401(k) contribution), our actual take-home pay is significantly less. This is the number that we record as our Adjusted Gross Income when we file taxes.

But finally, there’s the money that we actually have to use after all the bills have been paid. This is our disposable income and it has a lot to say about our personal financial health.

When it comes to looking at the financial health of a company you may be considering investing in, you will need to pay attention to the difference between revenue, profit, and retained earnings. Because what a company earns from selling their goods and services is vastly different.

This article will help explain these differences by focusing on retained earnings. We’ll review what retained earnings are, why investors pay attention to retained earnings, and why it’s important to understand how companies choose to use their retained earnings.

What are retained earnings?

Retained earnings tell you how much profit a company has left over after they have paid out dividends. Retained earnings are different from revenue in the way that disposable income is different from salary. They are more closely related to profit (net income) because a portion of a company’s profit may become retained earnings. To help explain this a little better beyond the technical definition, let's take a look at a company's balance sheet and operating cash flow.

A company's balance sheet is broken up into three basic areas: assets, liabilities, and shareholder's equity. At the top of the Assets, the section is a company's revenue. In the financial news, revenue is frequently referred to as the "top line". This is essentially all the money the company has raised from its operations. It could be called gross sales or gross income. Revenue can be a bit misleading. It’s important for companies to have money coming in. However, they also will have money coming out by way of their liabilities.

Loosely defined, the amount of assets over liabilities reflects a company’s profit. Ideally, a business will take in more than they have in expenses. But a balance sheet has to balance and that profit has to be offset somewhere. That’s where retained earnings come in. In our personal finance example, we noted that our take-home pay was different from our disposable income. In terms of a company, their net sales are the profit, but there’s one more layer … shareholder’s equity.

Retained earnings (also called earned surplus, retained capital or accumulated earnings) shows up under the Shareholder’s Equity section of the Balance Sheet. This is because retained earnings are the amount of money a company has earned AFTER any dividends have been paid out. This is a critical distinction that we will explain in the next section.

Retained earnings is a cumulative number

When you look at a company’s balance sheet, the retained earnings reflect that moment in time, but it also is a byproduct of their past earnings. Here’s an illustration.

Let's say a company had $10,000 of retained earnings in their first-quarter earnings report. In the second quarter, the company posted a profit of $10,000 and paid out $2,000 by way of a dividend. Their retained earnings for the second quarter would be:

10,000 + (10,000 – 2,000) = $18,000

In the third quarter, the company earned another $10,000 profit, but in addition to a $2,000 dividend had a $3,000 capital expense. Their retained earnings for the third quarter would be:

$18,000 + (10,000 – 5,000) = $23,000

Since retained earnings are a cumulative amount of profit, older companies will most likely have a larger amount of retained earnings. To get a better comparison between two companies, you can divide their current retained earnings by the number of years they have been in business. This will give you a per-year average.

What transactions affect a company’s retained earnings?

There are three basic transactions that affect retained earnings: net gains, net losses, and dividend payments. This is logical when you consider where retained earnings fit in on a company’s balance sheet. 

Net gains– When we earn more in salary, it means we can, potentially, have more disposable (retained) income. In the same way, when a company reports increased net income, they will usually show higher retained earnings. And since retained earnings carry over from one year, or quarter, to the next, they will continue to grow. 

Net losses– When our salary decreases or even sometimes if it just stays the same, we may see our disposable income decrease. The same is true for a company that experiences anything that results in a net loss. This could be an increase in an expense like rent, payroll or supplier costs that means it costs more to produce their goods and services. In the current tariff war, many U.S businesses saw the cost of aluminum and steel go up when the U.S. imposed tariffs. This could have an adverse effect on revenue if they have to pass along this cost to the consumer. Some companies operate in sectors where ongoing capital expenses are a part of doing business.

Dividend expenses– Since retained earnings are the amount of profit after any dividend payments, it stands to reason that when a company increases or decreases its dividend payment, it will have an effect on retained earnings as well.

Can a company report negative retained earnings?

Yes and no. In theory, a company could have a loss that exceeds the amount of profit that was previously in their retained earnings. For example, a company could issue a dividend that in the aggregate is greater than the total amount of its earnings since the company was founded. This is more likely in younger companies. However, this number usually appears as a debit balance rather than a credit balance under a line item titled “Accumulated Deficit” so it really is not possible to have negative retained earnings.

If the company continues to build on their accumulated deficit, it can be an indicator that the company is headed for bankruptcy. However, if the event was short-lived, it may not be an indication of future performance.

Why investors pay attention to retained earnings

As an investor, you would like a company to have positive, and growing, retained earnings. However, you would also like to see more money in your pocket by way of a dividend. What you really want is both … a company with strong retained earnings and a proven history of issuing a dividend.

When a company has a healthy amount of retained earnings, it can be an indicator that they have an ample cash reserve to pay out future dividends or issue stock buybacks. A second reason that investors focus on retained earnings is that this is money that could be used for future capital expenses. If the company does not have enough liquidity, they may have to fund these expenses by taking on debt, or by issuing more shares. As an investor, the issuance of new shares makes the shares you currently hold less valuable because, in virtually all cases, the stock price goes down.

A related reason why investors should pay attention to retained earnings is that they are an indication of how well a company manages their earnings and expenses. For example, many manufacturing companies and utilities find themselves in a constant battle to update old equipment and infrastructure to remain competitive. Usually, companies like these rely on a healthy dividend to entice investors who are willing to sacrifice growth for the consistent income they can receive from a dividend.

On the other hand, a start-up company may burn through a lot of their potential retained earnings to finance their growth. However, investors may reward a company like this by buying shares, and driving up the share price, because they like the company’s trajectory.

The bottom line on retained earnings

Just as there is a difference between what we earn in salary and what we count as disposable income, there is a difference between the gross revenue (or gross sales) of a company and their retained earnings. Retained earnings is that portion of a company’s profit that they set aside for future use. When you look at a company’s balance sheet, revenue is considered a “top line” number whereas retained earnings are listed in the shareholder’s equity section because it is there to balance a company’s assets.

The closer comparison for investment purposes would be the difference between our take-home pay and our disposable income because our disposable income is what we have to spend after we’ve accounted for our fixed liabilities. It’s the money that we are setting aside for future growth. In a similar way, a company’s retained earnings are derived from their profit, but after shareholder commitments have been made in the form of a dividend.

Retained earnings is a cumulative number. Ideally, it should grow over time. So the number a company reports in the third quarter is the sum of their retained earnings from the previous quarter plus the difference between new quarterly profit and money paid out as a dividend or share buyback. In this way, you would expect that a mature company might have higher retained earnings than a company that has only been in business a few years.

Investors care about the ratio between revenue and retained earnings because it can give them confidence that a company will be able to continue to pay dividends in the future. It also gives them an idea of how a company is investing in its future growth. In some cases, an abundance of retained earnings may indicate a company is being too conservative. Whereas in other cases, too little-retained earnings may indicate a growing company that is prudently expanding with hopes of future revenue. 

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