Any company that has made more profits in the past than it has distributed to stockholders will have a line on its balance sheet termed "retained earnings." While this line gives an idea about the corporation's past performance, it may or may not correlate with the cash at hand or the firm's ability to share the accumulated past earnings with shareholders.
The retained earnings which appear on a balance sheet represent historical profits which were not distributed to stockholders.
Balance Sheet Basics
All corporate balance sheets have two sides. On one side, the accountant lists all of the firm's assets, including cash, equipment, valuables such as stocks or foreign currencies, buildings, vehicles and so on. The other side lists the company's debt plus shareholder equity. In other words, the first part contains a list and dollar values of all that the firms owns, while the other side lists what the firm owes.
Technically, shareholders are owed money just as lenders are. The grand total of each side is equal to the other at all times. In fact, the accountant knows that his calculations are correct if the sum of asset values equals the sum of all debt plus shareholder equity.
As the corporation accumulates profits, its assets will grow; making a profit is nothing more than amassing a greater sum of assets, whether the asset in question is cash, receivables, buildings or any other valuable. Since the two sides of the balance sheet must be equal at all times, a profit and the resulting growth in assets must occur simultaneously with a growth on the other side.
This equation is ensured by growing retained earnings by an amount equal to profits. Retained earnings is part of shareholder equity and equals the sum of all past, undistributed profits.
At some point, the company will distribute some of the past earnings to shareholders as cash. These distributions are known as dividend payments and constitute an important source of income for most shareholders. When this happens, the retained earnings account will decline by an amount equal to the cash paid to stockholders. As a result, the two sides of the balance sheet will remain equal.
Assume, for example, that the owners of the company put down $10 million when the company was founded. Since then, the company has accumulated $1 million in retained earnings, bringing the total shareholder equity to $11 million. If the company pays half a million as dividends, the retained earnings account will decline to half a million and the total shareholder equity will come down to $10.5 million.
Retained Earnings Plus Cash
It is important to note that having retained earnings does not impose an obligation on the company to distribute these earnings to shareholders. Many companies elect to reinvest their retained earnings back into the business to grow their operations and have far less cash on hand than the retained earnings figure would suggest.
If the company has bought such hard-to-liquidate assets as buildings and factory equipment with its past profits, it may even face a cash crunch despite a significant retained earnings balance. Never assume that you will receive a dividend in the near future just because the issuing company of your shares has a great deal of retained earnings.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.