The balance sheet of a corporation contains three categories of accounts: assets, liabilities and stockholders’ equity. If you subtract liabilities (what is owed to others) from assets (what the company owns), the difference is the stockholders’ equity (the ownership value of the company). Among other things, the stockholders’ equity accounts record the firm's retained earnings, or accumulated profits. Expenses reduce retained earnings.
Corporations usually start out as private companies, in which their stock cannot be publicly traded and the company discloses only a limited amount of financial information. An initial public offering transforms a private company into a public corporation. In the process, the ownership value of the company is divided into common stock shares and sold to the public. The stockholders’ equity accounts track the amount of money raised by the sale of stock. When you buy stock, you are a partial owner of the corporation.
The retained earnings account within the stockholders equity section shows the unspent profits accumulated by the corporation since its inception. Profits are the earnings of the company after all expenses and losses have been deducted. Retained earnings can be used for starting or continuing company projects, buying assets, paying down debt, and paying dividends as cash or additional shares to shareholders. Not all stocks pay dividends, and dividends are not guaranteed to continue or to remain unchanged.
An expense is some cost of operating the company. The monthly and annual income statements disclose the income and expenses for the period. Expenses can relate to sales, administration, taxes, insurance, bond interest and many other costs. Non-expense costs include the purchase of assets and the payment of dividends, which are not categorized as expenses but rather as capital distributions. The income statement calculates the net income for the period by subtracting all the expenses from the gross income. The net income, or earnings, is then added to the retained earnings balance. A loss for the period would reduce the retained earnings balance.
Why You Care
As a stockholder, the stockholders’ equity section of the balance sheet reflects the value of your shares. If retained earnings fall, so do share value and stock price. You want unnecessary expenses to be avoided so that your stock price is not driven lower by poor management. Another determinant of stock price is earnings per share. Because expenses reduce earnings, high expenses hurt a stock’s earnings per share and thus its price. A vigilant shareholder keeps an eye on corporate expenses and questions unexplained increases. Because dividends can come only from retained earnings, high expenses can hurt your dividend income.
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