Knowledge Centre
Retained Earnings
This is the share of the company profits not paid out as a dividend but retained for investment in the business. Retained earnings could be utilised to fund working capital, increase capital expenditure, or to pay down debt. This reinvestment can then further grow future company earnings. At TEAM this is what we look to invest in.
At TEAM we particularly focus on RE. We look for growth where returns (ROIC) exceed the cost of capital (WACC) on a sustainable, and ideally, growing basis. A high and increasing RE means the company is growing its profits. An almost impossible ideal ratio of RE to Total Assets would be 1: 1 or 100%.
However, a ratio of 40% is solid. In other words, RE of $1 versus total assets of $2.5. This means 40% of the company assets have been financed by profits. The company is financing its growth without shareholders having to provide additional investment. At TEAM, this is an important characteristic to look for.
These retained earnings are reported in the balance sheet (shareholder equity, shareholder funds or shareholder capital).
Shareholder equity is the money shareholders would get if the company was liquidated. It can represent the net value or book value of a company.
RE are not reserves, although both do appear in the balance sheet. Basically, RE is net income left in the company after dividends while reserves are a part of RE set aside for a future specific purpose or purposes. Reserves have their own importance.
Retained earnings link the income statement to the balance sheet or value of the company.
Remember: RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Under the section on dividends we identified that dividends can only be paid out of profits or retained profits (reserves). A loss-making company with no reserves cannot pay a dividend. A company cannot pay out dividends greater than its available profits from current and previous financial years (retained profits).
Dividends are a reward to investors for committing their capital to the company.
RE may not always be a positive, as the current period’s net loss may be larger than that of the previous period RE. Alternatively, should a large dividend payout exceed the existing RE balance, the ratio may conceivably turn negative.
"Simply put, the more earnings a company retains, the faster it grows its retained earnings pool, which, in turn, will increase the growth rate for future earnings".