Retained earnings

Detained Darnings. After the equity earnings are subtracted from the net after-tax earnings, the balance is called the retained earnings and represents an iacrease ia equity. The retained earnings can be visualized theoretically as the new cash generated beyond that needed to provide for a return to iavestors and an orderly retirement of the investment. 

Similarly, the distinction between current and long-term liabihties is also not clear-cut. Current liabilities include accounts payable (money owed to creditors), taxes payable, dividends payable, etc., if due within a year. Long-term liabihties include deferred income taxes, bonds, notes, etc., that do not have to be paid within a year. The owners equity includes the par, or face, value of the capital received from stockholders and any retained earnings. The balance sheet shows only the nominal value and not the current or real value of this capital. 

Equity Financing Typically, the company balance sheet will show the stockholders equity and list the preferred stock, common stock, and retained earnings as in Table 9-23. 

Retained earnings Common-stock equity Total stockholders equity... 

Stockholders equity in a company is made up of the capital contributed by the stockholders and the capital generated from retained earnings. The presence of retained earnings on a balance sheet, as shown in Table 9-23, does not necessarily mean that they are matched by an equal amount of cash. In fact, there may be little or no cash available. The retained earnings shown on a balance sheet may be largely fictitious. For example, the assets on a balance sheet may be worth less than shown by at least the value of the retained earnings. 

Retained Earnings Much confusion is caused by the practice of dividing retained earnings under various headings such as reserve for replacement of plant, resei ve for contingencies, etc. This procedure also restricts the flexibihty of management in expenditure decisions. 

The amount of retained earnings shown on a balance sheet should not be taken as a measure of the amount of future dividends that the company is hkely to pay. A contract may exist that specifies a minimum balance of retained earnings, which is then not available for dividends until bonds issued by the company have been retired. 

Dividends can be paid either as cash or in the form of an additional issue of stock. A stock split is really a stock dividend, and both are used to reduce the price of stock when management considers that it is too high. A stock dividend is essentially a transfer of retained earnings to the common-stock account and makes the amount transferred unavailable for future dividends. A stock dividend may be used in place of a cash dividend when a company is short of cash. 

Row 3 in Table 9-24 is the return on equity (ROE) of Eq. (9-130). In this case, the net worth is the tangible net worth representing the sum of the preferred and common stocks and the surplus and undistributed profits or retained earnings, less any intangible items such as goodwill, etc. 

Equity is available from two sources. First, the company can sell new stock which, if in the form of ordinary shares, carries no interest payment. Although this course appears cheap, its use for projects which do not increase earnings, at least to a compensatory level, is usually inadvisable. This leaves retained earnings as the most likely source of equity for the present project. 

Equity holders require a real return on their outlay, which they assume to be at the stock-market price if this differs from the face value of the stock, of 7 percent net of all taxes. Retained earnings attract a 40 percent capital gains tax hence the actual interest rate required on distribution forgone is 7/(1 — 0.40) = 11.67 percent. This is in real terms and at a time of 8 percent inflation rate must be increased in cash terms to (1 -I- 0.1167)(1.08) — 1 = 20.60 percent. 

Equity financing comes 100% from the owners. They are in business to take risks but must realize a higher retuni to make up for this higher risk. Several ways are open to get equity funds. An asset may be sold, common or preferred stock may be sold, or retained earnings may be accumulated. Whatever the source, management must make sure the project is feasible, will pay the debt, and will make a profit. 

A company needs 300,000,000 for capital expansions in the coming year. This will be obtained from the following sources at the following cost of money Retained earnings and depreciation allowances 140,000,000... 

Assume the retained earnings are worth 10% after taxes. (Issuing new stock has administrative costs and it must be sold for less than the market value.)... 

A financial report contains two important documents—the balance sheet and the income statement. Two other documents that appear in the financial report are the accumulated retained earnings and the changes in working capital. All these documents are discussed in the following sections using a fictitious company. 

Internal funds Capital available from depreciation and accumulated retained earnings. 

Stockholders equity is the interest that all stockholders have in a company and is a liability with respect to the company. This category includes preferred and common. stock as well as additional paid-in capital (the amount that stockholders paid above the par value of the stock) and retained earnings. These are earnings from accumulated profit that a company earns and are used for reinvestment in the company. The sum of these items is the. stockholders equity. 

Remember that owner s equity represent the funds that an owner puts up to start the business. WHP s balance sheet indicates that the owners started with 300,000 of their own money. At the end of year 1, the owners have increased this amount by 200,000 to 500,000 owing to profitable operations during year 1. The owners could leave this extra 200,000 of profit to be used in the business (known as retained earning.s), or they could take some or all of the money to pay themselves (known as dividends). 

It also shows the net income for year 1. It is important to understand that the terms net income and earnings are used interchangeably in financial reports. You will note that the net income for year 1 is 300,000. The balance sheet (Table 15-2) shows retained earnings of 200,000. This is the portion of the net income that the owners have reinvested in the business. Where did the rest ( 100,000) of the net income go It was redistributed among owners as dividends (as depicted in Table 15-4). The connection between the net income value from the income statement and retained earnings from the balance sheet is an example of how these two reports are linked. In this particular example, the details of this linkage can be examined by the statement of retained earnings (Table 15-4). 

Table 15-4. Whole Health Partners Statement of Retained Earnings for Year 1 ( )...

Total noncurrent liabilities Total liabilities Shareholders equity Common stock Retained earnings Total shareholders equity Total liabilities and shareholders equity... 

The funds belonging specifically to the owners of the company are increased each year by the addition of the retained earnings from the year s operations. They may also decrease, if the company makes a loss, or if some are invested in new assets, or if the company chooses to pay dividends greater than the net profit (which, given good business reasons for so doing, the company is perfectly entitled to do). 

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