RETAINED EARNING RETAINED EARNING

Prepared BY: MAHMOUD ABO KMIAL

Retained EarningsRetained EarningsWhen a corporation makes a profit, it can spend When a corporation makes a profit, it can spend that profit in two waysthat profit in two ways::a) return the profits to stockholders by way of a) return the profits to stockholders by way of

dividends, share buy-backs or bonus issuesdividends, share buy-backs or bonus issues . . b) use the money to increase the b) use the money to increase the profitability of the companyprofitability of the company  What Does What Does Retained EarningsRetained Earnings Mean? Mean?

The percentage of net earnings not paid out as The percentage of net earnings not paid out as dividends, but retained by the company to be dividends, but retained by the company to be reinvested in its core business or to pay debt. It is reinvested in its core business or to pay debt. It is recorded under shareholders' equity on the recorded under shareholders' equity on the balance sheet. balance sheet.

Retained EarningsRetained Earnings

The formula calculates retained The formula calculates retained earnings by adding net income to earnings by adding net income to beginning retained earnings and beginning retained earnings and subtracting any dividends paid to subtracting any dividends paid to shareholders:shareholders:

Austin Driving School, Inc.Austin Driving School, Inc.Partial Balance SheetPartial Balance SheetDecember 31, 2008December 31, 2008Stockholders’ EquityStockholders’ Equity

Paid in Capital:Paid in Capital:Common Stock Common Stock $20,000$20,000Paid in Capital in Excess of Par, CommonPaid in Capital in Excess of Par, Common 180,000180,000Paid in Capital from Treasury Stock Paid in Capital from Treasury Stock TransactionsTransactions 3,6003,600 Total Paid in CapitalTotal Paid in Capital $203,600$203,600

Retained EarningsRetained Earnings 100,000100,000 SubtotalSubtotal $303,600$303,600Less Treasury Stock (400 shares at cost)Less Treasury Stock (400 shares at cost) 5,6005,600Total Stockholders’ EquityTotal Stockholders’ Equity $298,000$298,000

Retained EarningsRetained Earnings Therefore, the statement of retained Therefore, the statement of retained

earnings uses information from the income earnings uses information from the income statement and provides information to the statement and provides information to the balance sheetbalance sheet

Retained earnings are part of the balance Retained earnings are part of the balance sheet (another basic financial statement) sheet (another basic financial statement) under "stockholders equity,"under "stockholders equity,"

The retained earnings account on the The retained earnings account on the balance sheet is said to represent an balance sheet is said to represent an "accumulation of earnings" since net profits "accumulation of earnings" since net profits and losses are added/subtracted from the and losses are added/subtracted from the account from period to period.account from period to period.

Retained EarningsRetained Earnings In broad terms, capital retained is used to In broad terms, capital retained is used to

maintain existing operations or to increase sales maintain existing operations or to increase sales and profits by growing the business. and profits by growing the business.

In other words, a company that aims to grow In other words, a company that aims to grow must be able to put its money to work must be able to put its money to work

Retained earnings should boost company value Retained earnings should boost company value and, in turn, boost the value of the amount of and, in turn, boost the value of the amount of money you invest into it. The trouble is that most money you invest into it. The trouble is that most companies use their retained earnings for companies use their retained earnings for maintaining the status quo. If a company can use maintaining the status quo. If a company can use its retained earnings to produce above-average its retained earnings to produce above-average returns, then it is better off keeping those returns, then it is better off keeping those earnings instead of paying them out to earnings instead of paying them out to shareholders shareholders

Evaluation of retained earningsEvaluation of retained earnings

When evaluating the return on retained When evaluating the return on retained earnings, you need to determine whether earnings, you need to determine whether it's worth it for a company to keep its it's worth it for a company to keep its profits. If a company reinvests retained profits. If a company reinvests retained capital and doesn't enjoy significant capital and doesn't enjoy significant growth, investors would probably be better growth, investors would probably be better served if the board of directors declared a served if the board of directors declared a dividend.dividend.

Evaluation of retained earningsEvaluation of retained earnings

Another way to evaluate the effectiveness of management in its use of retained capital is to measure how much market value has been added by the company's retention of capital

Evaluating by Market Value

Important of retained earningImportant of retained earning

It is important to understand that retained It is important to understand that retained earnings do not represent surplus cash or earnings do not represent surplus cash or cash left over after the payment of cash left over after the payment of dividends. Rather, retained earnings dividends. Rather, retained earnings demonstrate what a company did with its demonstrate what a company did with its profits; they are the amount of profit the profits; they are the amount of profit the company has reinvested in the business company has reinvested in the business since its inception. These reinvestments since its inception. These reinvestments are either asset purchases or liability are either asset purchases or liability reductions. reductions.

Important of retained earningImportant of retained earning

Capital-intensive industries and growing Capital-intensive industries and growing industries tend to retain more of their industries tend to retain more of their earnings than other industries because earnings than other industries because they require more asset investment just to they require more asset investment just to operate , older companies may report operate , older companies may report significantly higher retained earnings than significantly higher retained earnings than identical younger ones identical younger ones

importance of retained earnings as a importance of retained earnings as a source of funds for growth source of funds for growth

Important of retained earningImportant of retained earning

important to note that the retained important to note that the retained earnings will enter the wealth of the earnings will enter the wealth of the investorinvestor

ConclusionConclusion

For stable companies with long For stable companies with long operating histories, measuring the operating histories, measuring the ability of management to employ ability of management to employ retained capital profitably is relatively retained capital profitably is relatively straightforward. Before buying, straightforward. Before buying, investors need to ask themselves not investors need to ask themselves not only whether a company can make only whether a company can make profits, but whether management can profits, but whether management can be trusted to generate growth with be trusted to generate growth with those profitsthose profits..