Retained Earnings

My experience with financial statements says that one of the terms in accounts which need to be understood better is Retained Earnings.
The purpose of capital retained is two folds:
· Maintain existing operations (maintenance capex) or
· To increase future earning capacity by expanding the business (growth capex).
Some companies need large amounts of new capital just to keep running. Others, however, can use the capital to grow. When you invest in a company, you should make it your priority to know how much capital the company appears to need and whether management has a track record of providing shareholders with a good return on that capital.
Most of us have no difficulty in understanding that whatever is not paid as dividend is transferred to reserves as retained earnings. Hence, retained earnings refer to funds generated by the company through its operations and ploughed back into business.
However, the problem starts when retained earnings is used to buy an asset. A lot of students assume that as retained earnings has been used to purchase the assets; retained earnings balance needs to reduce. However the same does not happen. We buy assets either by taking a loan hence debt goes up or by utilizing cash balance hence cash goes down. The rationale for not decreasing retained earnings is that retained earnings is just a “notional amount which tracks the amount invested in the company, it’s important to know where this money is going.

Now the million dollars question “How does the retained earnings than decrease?”
There are two ways:
1. There is a negative net income in other words loss.
2. The company utilizes reserves and surplus to pay dividends.even when the company has earned losses.
Relevance of reinvestment earnings
· Reinvestment of retained earnings can be an important source of financing for many companies. Lenders are often interested in the retained earnings. This is because company’s which use retained earnings to pay dividends when they are running in a loss are not preferred by lenders.
· A company’s performance is judged by it’s ability to make it’s retained earnings grow at a rate higher rate than market rate. Retained earnings should increase returns in the long run. The trouble is that most companies use their retained earnings for maintaining the status quo. If a company can use its retained earnings to produce above-average returns, then it is better off keeping those earnings instead of paying them out to shareholders.

Author: Abhishek Sinha

Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +

Ratio Analysis - Beware - Not as easy as it appears

Ratio analysis is a mathematical tool that enables us to gauge the comparative performance of a company. Ratios could be used to compare the performance of a company:
· vis-a- vis it’s competitors,
· or to judge it’s performance compared to past performance.
Before you deep dive into the world of ratio analysis it is worthwhile to emphasise on the purpose of carrying out this exercise. The purpose of ratio analysis is not to merely calculate the value of ratios. The purpose is to gauge the health of the organization through proper analysis. Hence, emphasis should be equally on both the inputs and the formula. Following are certain checks you need to carry in order to ensure that the ratios serve the purpose for which it is being computed:
· Understanding the industry and the company: Every company has a story. Numbers just help us understand the story better. Hence, when we want to narrate a story careful choice of inputs to the ratio makes sure we have the logical understanding of the story. Here are certain illustrations to drive the home better.
1 The company which has a pension liability equivalent to the market value of debt would have to account for the pension liability value in calculating Enterprise Value (EV), for any of the EV ratios.
2 If a company has historically, been sitting on huge piles of cash it would be prudent to net out excess cash while calculating Net Working Capital.
· Consistency factor: Whenever we build a framework for analysis in the real world there are a lot of assumption that we make. However, “the logic remains fractured” if we do not make our assumptions pertaining to the numerator and denominator consistent. Here are few examples:
o Whenever we account for a Capital Lease in Return on Asset ratio we would also have to net out expenses pertaining to interest and depreciation
o Any ratio that involves both expenses (income statement item) and assets (balance sheet item ) needs to be made consistent. This is because balance sheet records an item as on date whereas income and expenditure records all entry for a period. Thus, we average the opening and closing balance sheet item to make the items comparable.
· Source of input: It takes time for an amateur to understand how the sources for the input can make a difference. The preferred source for the data generally is annual reports and conference call transcripts. However, at times we are forced to pick up data directly from the databases. When picking data from the databases it is always good to go through the definitions of the terms and remove affect of adjustments with which the analyst does not agree.

Author: Abhishek Sinha

Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +