How Companies use Retained Earnings?

How Companies use Retained Earnings - image

How companies use retained earnings, says a lot about their core strengths and business practices.

Qualified investors analyse companies with a critical view on their retained earnings.

Lets understand how retained earnings gets build-up over time.

Net profit (PAT) figures that we see in companies profit and loss accounts can serve two purpose.

  • To pay dividends
  • To increase retained earnings.

Net Profit (PAT) can be used to distribute dividends among shareholders.

PAT can also be “transferred” to the balance sheet as retained earnings.

So the question is, what do companies do with retained earnings?

To understand how companies use retained earnings, we must get a thing clarified beforehand.

What are retained earnings?

It is not companies savings (or cash) stacked in bank accounts or lockers.

Instead, The retained earning is that money that must be “always at work”.

How Companies use Retained Earnings - 1

#1. Effective utilisation of retained earnings

It is an obligation of the top management to use retaied in the most effective way.

Why it is essential?

The retained eanings are recorded in companies balance sheet as “Shareholders Equity.”

The retained earnings are actually shareholders money which has been retained (not paid as dividends).

So, when a company’s management decides to retain profits, they must assure that this money gets utilized well.

#2. How retained earnigs can be used?

I am not sure, but I think that there are no specific rules or guidelines regarding utilization of retained earnings.

But generally speaking, a good company use retained earnings as following:

  1. Maintaining or improving its competitive advantage,
  2. Prepay debts,
  3. Buy investments, and
  4. Fund existing operations.

If I am not wrong, a good company would like to utilize the retained earnings in this priority.

#2.1 Maintaining or improving competitive advantage

What is competitive advantage?

When a company has an “edge” over its rivals, it is said to be enjoying a competitive advantage.

Having an edge means, “prevailing conditions that helps the company to maintain or improve its current sales and profit levels”.

Yesterday, I heard a news that GlaxoSmithKlin (GSK) is selling its top brand “Horlicks”.

This product horlicks gives a huge competitive edge to GSK.

The market share of horlicks and other health drinks in India is as below:

  • Horlicks – 50%
  • Bournavita – 16%
  • Complan – 14%
  • Boost – 12%
  • Others – 8%

[GSK is supposedly selling Horlicks to fund its purchase of Novartis]

For a brand to enjoy a market share like horlicks (50%), it needs lots of effort.

One such effort is to ensure that the retained earnings get utlized to further increase the companies:

  • Sales and
  • Profitability

To improve sales and profitability, the company must either expand its capacity or modernize its facility to make it more productive.

For both expansion and modernization’s plans companies need to buy assets (land, building, equipments etc).

For this, the company will need funds.

In order to generate funds, companies can either borrow loan from banks/market or it can use its own profit (retained earnings).

#2.2 Prepayment of debt

Another very effective use of retained earnings is prepayment of debts.

Companies need money time and again to fund its operations or capex plans.

Only few companies has excess retained earnings. Hence majority resort to bank loans (debt).

Taking loan is not bad, but if the level of debt/equity ratio becomes too high, then it is a point of concern.

Hence, good companies use their retained earnings, to keep their debt/equity ratio withing acceptable limits.

How they do this? By prepayment of debts.

#2.3 Buy investments.

Like we buy investments for self, companies can also buy investments from their retained earnings.

They can invest in:

  • Bonds, deposits, debt based mutual fuds etc.
  • Stocks in primary market.
  • Buy majority stake or complete takeover of other companies.
  • Land, real estate properties.
  • Equity linked mutual funds etc.

When a company prefers to buy an investment?

The primary use of retained earning is for the purpose of expansion or modernization of exiting facilities (#2.1).

Then they can also use the funds to prepay their debts (#2.2).

When the above two (#2.1 and #2.2) are not the one that can be classified as “effective use of retained earnings”, company can decide to buy investments instead.

Yes, this can also happen. Putting retained earnings for “internal use” or “debt prepayment” is not as effective. How?

  • When companies profitability is not as high.
  • There are no plans for expansion or modernization.

In such situations, it is better to use the retained earnings elsewhere. This may generate better returns.

#2.4 Fund existing operations.

All companies need funds to operate. In financial terms it is called as “working capital”.

Working capital is used for the following:

  1. Bill payments (utility, suppliers, office overheads etc)
  2. Pay salaries to employees.
  3. Maintenance management.
  4. Employee training etc.

These are all such capital needs which are of short term in nature.

Though it may sound non-important, but they are like blood flowing in the veings of the company.

It is of paramount importance for the company to maintain this cash flow to continue doing business.

If a company is not in CAPEX mode, major portion of the retained earnings are used to fund companies operation needs.

#3. Retained Earnings and EPS

There can be a condition where companies retained earnings are growing faster than its EPS.

It it a sign of danger? Investors must worry about it?

Lets take a real life example of TCS.

How Companies use Retained Earnings - 2

In last 5 years, the growth trend has been as below:

  • Retained Earnings / Share (REPS) growth – 19.1%
  • Earning / share (EPS) growth – 13.0%

It means, EPS is not growing as fast as Retained Earnings.

What does it mean?

The retained earnings has not being used as effectivley by TCS?

The conclusion is so simple? No.

#3.1 PAT, Dividends, Retained Earnings and Market Price

What a company can do with its net profits (PAT)?

Company can either distribute dividends, or retain it.

The retained earnings must ensure long term gains for its shareholders.

Form point of view of shareholders, EPS growth is very important.

Because any growth in EPS is automatically reflected in market price of its shares.

So lets see how market price of TCS behaved in last 5 years:

  • March’2013 – Rs.1,560 / share
  • March’2013 – Rs.2,870 / share

This is a growth of 13.1% CAGR (from 1560 to 2870) in last 5 years.

What we can conclude here?

For a good company like TCS, market price almost replicates its EPS.

But it is not only market price which profits shareholders. TCS’s shareholders has also earned dividends:

In last 5 years, TCS has paid dividends as below:

  • March’13 – Rs.22/share
  • March’14 – Rs.32/share
  • March’15 – Rs.79/share
  • March’16 – Rs.41/share
  • March’17 – Rs.46/share

Considering the combined impact of Dividend plus price appreciation, lets calculate the net effective return of TCS’s shareholders:

  • Capital Appreciation – Rs.1,310 (2870–1560)
  • Dividend earnings – Rs.220 (22+32+79+41+46)
  • Effective Profit – Rs.1,530
  • Yield in 5 years (CAGR) – 14.72% [((1560+1530)/1560)^(1/5)-1]

Compare this Yield (CAGR) with retained earnings (REPS) growth rate of 19.1% per annum.

  • Shareholders Yield(price growth + dividend) – 14.72% p.a.
  • Retained Earnings Growth – 19.1% p.a.

What does it conclude?

Retained earnings has not been very effectively utilized for increase shareholers value.

Conclusion

Though shareholders yield of 14.72% p.a. is not bad in any sense. But the question is, is it good enough?

On one side, the company has increased its Retained Earnings Per Share (REPS) at rate of 19.1% p.a.

But on other hand, shareholders yield has seen a growth of only 14.72%.

The point is, if we had seen only shareholders yield of TCS, 14.72% is a number which would look very impressive.

But comparing it with Retained Earnings Per Share growth rate brings forward a different realization.

Now the question arises, how effectively TCS is using its retained earnings?

Final words…

We are talking about a company like TCS, which is considered as a benchmark of good corporate governance.

In last couple of years, the Indian IT sector has been under pressure.

Profit and profitability both has taken a beating.

In such tough conditions, TCS has ensured shareholders yield of 14.2% p.a. (against REPS growth of 19.1%).

So hats-off to TCS.

But the point to note here is, how effective it is to use the retained earnings analogy to dig deeper into companies fundsmentals.

I hope you liked this small case study.

How companies use retained earnings to ensure good shareholders yield, is a very important parameter to judge the company’s core strenghts.

Hence investors use a metric called ROE and ROCE to do fundamental analysis of stocks.

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