Why investors need to know about retained earnings? Because it is the money of the shareholders. How? When we buy stocks of a company, we are actually buying a share in company’s ‘net profit’.
Technically speaking, net profit generated by the company are the ‘owner’s money’. Who are the owners of a publicly traded company? It’s the shareholders. How shareholder can get hold of the net profit? In form of dividends.
But companies often do not distribute 100% of their net profits as dividends to its shareholders. They retain a chunk of net profit. These are called retained earnings.
We generally see cumulative retained earnings indicated in the company’s balance sheet as “reserves“.
What’s Retained Earnings
It is that portion of company’s net profit (PAT) which is not paid to the shareholders as dividend at the end of a financial year. This portion of net-profit has been said to be retained by the company.
What we see in company’s balance sheet is the “accumulated” retained earnings. “Retained profits” of each financial year (like 2019, 2018, 2017, 2016, 2015 etc) accumulated to become “Reserves” as seen in balance sheet.
Retained Earnings Statement (Example)
What is retained by the company is a portion of net profit which is not paid to the shareholders. Let’s see how companies prepare their retained earnings statement for each financial year:
- Step #1: The first step is to note the retained earnings balance of the previous year. In our example, this number shall be taken form the balance sheet of FY ending Mar’18 (Rs.50,179.64).
- Step #2: Second step will be to note the net profit reported for the current year. In our example, the net profit reported for Mar’19 is Rs.12,464.32. Read: Fundamentally strong stocks.
- Step #3: In this step note the total dividend expense reported by the company in current financial year (Mar’19). Total dividend expense will be sum of dividend paid to shareholders plus dividend tax. In our example, total dividend expense is Rs.7,486.90. Read: Dividend analysis of stocks.
- Step #4: Calculate retained net profit by subtracting total dividend expense (step 3) from reported net profit (step 2). In our example, retained net profit is Rs.4,977.42 (=12,464.32 – 7,486.9).
- Step #5: Calculate current year’s retained earning by adding current year retained net profit (step 4) to previous year’s retained earning balance (step 1). In our example, current year retained earnings will be Rs.55,157.06 (= 50,179.64 + 4,977.42).
How Depreciation Affect Retained Earnings?
I’ll share with you my personal confusion related to “depreciation expense” and its affect on retained earnings. As depreciation is a non-cash expense, I thought, why it is not carried over to balance sheet (along with retained net profit) and added to the accumulated retained earnings?
[My confusion: The depreciation reported in profit & loss account should increase the reserves. But in actual practice, due to depreciation, retained earnings is reduced (as net profit is reduced)]
To clear this confusion, we will have to understand what is depreciation expense an how is the cash flow happening related to depreciation.
Allow me to explain it with an example. Suppose there is a company which purchased an equipment in Mar’2019 worth Rs.500 Crore. The life of this equipment is say 4 years.
Cash Flow: On the date of purchase of the equipment (Mar’2019) the company paid full Rs.500 crore to its supplier.
How this cash out will be reported in company’s financial statement?
The actual cash-out due to purchase of equipment has happened on Mar’19 itself. But the same need not be reported immediately as expense in profit and loss account. The cost of equipment purchase can be spread over the life of the equipment as depreciation (see the above infographics).
In this case the life of equipment was 4 years. Hence Rs.500 crore was evenly distributed as Rs.125 crore for next 4 years (125×4 = 500).
So what we can conclude? Though depreciation is a non-cash expense for the current year, but the cash-out has already happened in the past. The present depreciation reported is an adjustment of the already-paid expense. But as we have not adjusted it then, the same is being reported now. Due to non-cash depreciation expense, there is no extra cash lying idle with the company. Hence, we cannot add depreciation to company’s retained earnings.
Where Do Retain Earnings Go?
Profits are retained by the company to ensure future growth of its business.
It is an obligation of the top management to use retained earnings in the most effective way. Why it is essential? Because retained earnings are recorded in companies balance sheet as “Shareholders Equity.”
Retained earnings are actually shareholders money. So, when a company’s management decides to retain profits, they must assure that this money is utilised well (in the interest of the shareholders).
Use Of Retained Earnings
As you can see in the above flow chart, retained earning ultimately settles as “cash” in the companies balance sheet. But companies do not prefer to keep them as cash for long time.
Companies would like to utilize retained earnings in a way which ensured future growth. Which are the most preferred ways to do it? Please see the below list:
1. To Fund Working Capital
For any company, the first priority to use retained earnings is to fund its working capital. Working capital is that money which is required to keep the company running.
Sufficient working capital helps a company to keep all its stakeholders happy. Employees are happy as they get their salary and pay-hikes on time. Suppliers are happy as they get due payments within schedule. When employees, and suppliers are happy, they together as a team keep the customers happy ensuring future growth prospects.
What is working capital? It is the total liquid capital available with the company to manage its day to day operations.
Working capital can also be understood as that “portion of current assets which is available with the company to manage daily operations”. Here the useful portion of current assets which can be used to fund working capital is cash, account receivables, and inventory.
There are two ways to fund working capital, either it can be done through equity or debt. Out of the two, equity (retained earnings) is preferred by the companies. Read more: Why equity is preferred over debt.
2. To Fund Fixed Asset Purchase
Retained earnings can also be used to fund CAPEX plans of the company. Capex is basically an expense undertaken by the company to expand or modernise its capacity.
- Expansion: Under Capex, company execute projects to buy’s new land, buildings, machineries, furnitures, equipments etc as a part of their expansion plans.
- Modernisation: The company may also undertake projects to enhance the effectiveness and modernise their existing production facilities.
3. To Fund Other Needs
Companies also use retained earnings to strengthen their sales force, Research & Development department, buy investments, to prepay loans, buyback shares etc.
- Prepayment of Loan: Debt adds to the company’s liability. The lower is the company’s liability, lower will be the expenses and risks associated with it. Hence company’s often use their retained earnings to pay-off their debts (specially long term debts).
- Buy Investments: Like we buy investments for self, companies can also invest their retained earnings. Investments like bonds, deposits, mutual funds, stocks in secondary market, takeover of another company, real estate property etc.
- Shares Buyback: When a company buys its own shares from the secondary market, it is called shares buyback. Company buying its own shares decreases the number of shares outstanding in the market. This improves company’s per share valuation like EPS, dividend per share, book value per share etc. These improvements benefits shareholders in long term in terms of price appreciation of their shares.
- R&D Facility: When a company invests in their research and development facility, they do it with the purpose of improving their line of products. Improved products results is bigger customer base leading to more profits and profitability.
- Sales Force: Company can also use retained earnings to establish new sales offices in different geographical locations. They can also use the funds to hire competent sales team. These new additions ultimately benefits the company in terms of more sales in times to come.
4. To Pay Dividends in Future
There are times when company may want to use their reserves to pay dividends. These are times when company is sure than reinvesting the money back into business will not yield good returns. In such cases, companies distribute dividends.
There may also be case where the company has made a net loss in the current financial year. In this case, company will use its past reserves to pay dividends to shareholders to keep them happy.
FAQ’s on Retained Earnings
#1. Why company prefer to retain earnings?
Company retain their earnings to use them for above listed #4 purposes. The priority being: funding working capital, Capex plans, loan prepayment, share buyback etc.
If the company has not retained its earnings, which other option is available to fund their working capital, Capex etc? The other option is debt (loan from bank).
But loan comes at a cost. Company is obliged to pay the interest and principal back to the borrower. Though loans can also fund the same needs as equity (retained earnings), but they increase the company’s expenses due to extra interest load.
While on the other hand, equity funds has no obligatory cost for the company. Hence, better utilisation of equity can create more value for its shareholders.
#2. When a company may prefer to retain its earnings instead of dividend disbursement?
Generally speaking, management of a company knows that shareholders love dividends. But they may still not pay the dividends. Why?
Because management is sure that more shareholders value can be created by reinvesting the profits back into the business.
Blue chip stocks (matured companies) pay best dividends. Why? Because such companies have already exhausted their options for fast future growth. Even for such companies, how much dividend yield we can expect in a 5 year time horizon? 5-6% per annum.
But if the retained earnings in properly used (as stated above), over a period of 5 years, shareholders can easily expect 10-12% returns per annum.
Hence, for a company which is confident of such future growth rates, they will like to use retained earnings to funds their Capex, Working Capital etc instead of paying dividends. Read: About dividend yield formula.
In short, growth focused companies either pay no dividends or their dividend disbursement is very low.
#3. What happens to retained earnings when a company reports a net loss?
Even in case of loss reporting (negative net profit), the same is carried over to the company’s balance sheet and added to the previous years reserves. The only difference is that, when losses are carried over it reduces the accumulated retained earnings in the balance sheet.
#4. How companies decide of reinvestment of dividend payment?
If the generated return is less than cost of capital, company would prefer distributing profits as dividends instead of reinvesting.
If the generated return is more than cost of capital, such companies are often referred as growth stocks. Such companies are growth focused and they prefer retaining majority portion of their net profits.
How to know if the company is generating enough returns or not?
Company’s retain profits to improve shareholders returns. How? By assuring faster market price appreciation of its shares.
Though shareholders of such companies may not benefit much in form of dividends, but they will benefit in form of price appreciation in long term. How? By the following 4 after-effects of ‘good utilisation’ of retained earnings (See point marked #A, #B, #C, & #D marked in the flow chart).
- #A. Income Increase: A company which is utilising its retained earnings properly (by expanding and modernising its facility) will eventually increase its income.
- #B. Net Profit Increase: Efficient utilisation of retained earning will make the company more efficient. It will spend less and earn more. Hence the company will make more profits.
- #C. EPS Increase: Increase in net profits eventually leads to higher EPS. This should be the ultimate objective of a company. A continuously growing EPS is something which best influences the market price of its stocks. Read more about high EPS stocks.
- #D. Market Price Increase: When EPS grows, market price will also grow at a similar pace. Here at this step, the shareholders actually benefit from retention of earnings over a period of time. Read more about highest return stocks here.
Example 1 – Berkshire
Warren Buffett’s company Berkshire Hathaway pays almost zero dividends. It retains majority portion of its net profits. Let me show you how EPS and market price of Berkshire Hathaway has grown in last 5 years (2014 to 2018)
|Retained Earnings ($ Mn)||3,21,112||2,55,786||2,10,846||1,87,703||1,63,620||14.44%|
|Market Price ($)||3,42,600||2,97,600||2,44,121||1,97,800||2,26,000||8.68%|
In last 5 years, retained earnings has grown at a rate of 14.44% per annum. But in the same period, the market price of Berkshire Hathaway has grown by only 8.68% p.a.
As per the standards of Warren Buffett, the price appreciation should have been more than retained earnings growth. Moreover, EPS growth is negative in the same period.
Example 2 – VIP Industries
We have a company in India which paid 48% of its profits as dividends (in last 5 years). The balance 52% was retained. Which is this company? VIP Industries. Let’s check how the EPS and market price of VIP has grow with respect to its “reserves growth”.
|Financials||Mar ’19||Mar ’18||Mar ’17||Mar ’16||Mar ’15||5Y Growth|
|Market Price (Rs.)||450||316.8||196.9||105||93.2||37.01%|
In last 5 years, retained earnings has grown at a rate of 13.21% per annum. But in the same time period, EPS has grown by 21.86%, and the market price of VIP Industries has grown by 37.01% p.a.
Comparing EPS and price growth with retained earning growth is a good way to check if the company is utilising well its retained earnings or not.
When you will check more companies, you will find that even best companies will not pass this litmus test.
What is the litmus test? Last 5/10 years EPS and price growth must be more than retained earning growth.
I have checked this with TCS and Eicher Motors, they did not pass the test. I will request you to check for your stocks and post the results in the comment section below.
Having said that, it is also true that companies cannot convert retains earnings into EPS growth, within a short time horizons. Shareholders must give them more time (like 5+ years).