How Companies use Retained Earnings?

By | March 21, 2012
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How companies use retained earnings says a lot about its fundamental strength. Qualified investors analyse companies with critical view on retained earnings. Net profit (PAT) figures that we see in companies profit and loss accounts can serve two purpose. Either it can be distributed among shareholders or it can be transferred to balance sheet as retained earnings. When profits are retained, company use this fund to gain competitive advantage. The competitive advantage can be achieved by increasing sales or by increasing profit margin. To improve sales or margins company shall either expand its capacity or modernize its facility to make it more productive. For both expansion and modernizations plans companies need funds. Now, in order to generate funds, companies can either borrow loan from banks/market or it can use its own profits.

Its important to check how retained earnings are used by company!

When companies board, on behalf of shareholders, allow company to retain its profits then shareholders must know how company is using their funds. How companies use retained earnings is a question that needs to be asked by all investors. In this article I will try to answer what a shareholder-friendly company does with its retained earnings. Retained earnings are originally shareholders shares of profit. This is the reason why retained earnings are shown as shareholders equity in the balance sheet. For investors it is important to look closely into balance sheet and profit-loss statement together. If investors observe that companies retained earnings are growing fast, but EPS growth rate is not proportional then it is a sign of danger. Company can either distribute dividends or give long term capital appreciation. But if investor is gaining nothing, then it will be better to see an alternative. So, comparison of retained earnings growth (5Yrs) and EPS growth (5Yrs) is important.

How Companies Use Retained Earnings

There is a simple way to check if a company is using retained earnings profitable or not. Suppose, a company whose EPS was $48.0 in year 2009. In the same time it had retained earnings of say $15 million. In 2009 the companies board decided to use these $15 million to fund a modernization plan. This process was followed for next five year. By 2013 EPS of company has grown to $65. It means that the EPS has grown from $48 to $65 mn in five years at a rate of 6.25% per annum. Compare this growth rate with the risk-free rate of the market. If the company is able to grow its retained earnings at a rate higher than risk-free rate it is a good value indicator. Idea is like this, every dollar of retained earnings used by company should convert into value for shareholders. Value from retained earnings can be created by maintaining healthy EPS growth rate.

Top 3 Companies Listed in NASDAQ Stock Market and their ROE are as below. All these 3 companies are global giants. Apple Inc. has retained earning of $101,289 millions as on today. The average returned that it gave to its shareholders over a period of five years is a whooping 39% per annum on equity. Similarly for Microsoft and Google, just by looking at ROE column, we can understand that these companies are using retained earnings very profitably for its shareholders. It is also interesting to see what are the debt levels of these companies. There can be a case where companies are not only retaining shareholders profits but also amassing huge debts for itself. This is a worst case scenario. But just check how these top 3 companies have performed in terms of debt accumulation. Apple Inc. is a debt free company. Google and Microsoft have debt of 4.17% and 15% respectively compared to its equity. High ROE and Low debt levels are perfect signals for investors. These companies are really good.

SL Company name Market cap Retained Earnings Million $ Return on equity (5 yr avg) (%) LT Debt Equity %
1 Apple Inc. 438.83B 101,289 39.24 0.00%
2 Google Inc 290.68B 37,605 18.43 4.17%
3 Microsoft Corporation 282.22B 9,895 35.73 15%

Conclusion

For long term investors it is as important to see companies profits (EPS). But us also important to check how company is using the retained earnings.  If companies retained earnings is growing year after year, investors mush check how well these earnings are used by the management. One of the best metric to check use of retained earnings is by looking at ROE and debt/equity levels.


Article Checked by Getmoneyrich

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