Retained Earnings and Dividends Retained earnings are a major parameter when analyzing a company. Shareholders look forward to retained earnings in the hope of dividends.
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Online trading brokerages have made trading stocks easier with advanced trading platforms for online stock trading. But you still need to make the right choice in selecting the right stocks. That’s where the opinions and perspectives of experienced analysts matter. While studying the health of stocks and the businesses they represent, you will inevitably study the earnings of a business and analyze whether these earnings help it make a profit or loss. While losses could befall a company and that’s something to be accepted, profits provide the business management with surplus money to use for whatever reason they feel like. Retained Earnings and Retention Ratio You also look at something known as retained earnings (RE). Investopedia analyst Mark Kenton sheds some light on RE. Retained earnings, also known as earnings surplus, refer to the money retained by the company for use within its business. Funding activities and investments are some of the internal activities for which retained earnings can be used. RE makes up the profits or cumulative net earnings of a company after dividend payments have been accounted for. This money is available for the company to reinvest in itself. RE is also depicted as retention ratio, in terms of the total earnings percentage. Retention ratio is 1 – dividend payout ratio Debt repayment is also included in retained earnings since it does impact the business accounts, though the money for paying off debts leads to money going out. Calculating Retained Earnings RE is calculated as: Beginning period RE + net income - cash dividends - stock dividends This RE figure is calculated as each quarterly or annual accounting period ends. Retained earnings depend on the corresponding earnings period from the previous term. Depending on the net income, the RE amount could end up being positive or negative. RE could also be negative if the company pays massive dividends exceeding the other figures here, and any other item such as operating expenses, sales revenue, depreciation and COGS (cost of goods sold) does impact the net income of the company. Kenton quotes Apple’s ($AAPL) recent balance sheet, where it is depicted to have earned retained earnings worth $79,436 billion at the quarter of June 2018.
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Why Dividends Are Instinctively Thought of with Retained Earnings Long-term shareholders expect dividends as a regular income whenever their company earns income in surplus. Even traders looking for gains in the short term might prefer dividend payments as a means of instant gain. And since dividends are tax-free in many places, while stock gains are taxable, it is something most shareholders prefer. But equally, the management of the company could also think that saving on dividends can help them use the money for their business needs. In some cases, when shareholders put total trust in the company management, their preference would be to allow the company to retain its earnings in the belief that there could be significantly higher future returns. Dividends Not Always the Option to Spend Retained Earnings A company focused on growth could decide not to pay dividends, or pay small amounts, in order to use its retained earnings for financing its marketing efforts, research and development, acquisitions, capital expenditures and other requirements of working capital. On the other
hand a company that is maturing could not be having projects
generating high returns and so would not be able to make use of the extra cash. Such companies would be willing to hand out dividends though RE ends up being low.
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In many cases though, there isn’t much confusion or difference in opinion between the shareholders and the company management. Both parties agree for the company to get its earnings retained. That’s because the management might have some high growth project in mind. Shareholders trust the management and lend their support to it with the hope of generating significant returns ahead. Those returns would be greater than what dividend payouts offer. Shareholders would also be willing to let the company pay off any high interest debt it has, rather than paying dividends. In most cases, Kenton reports, the company management pays a nominal dividend while retaining the remaining part of its earnings for its business purposes. Dividend Cash Payment Dividends are distributed as stock or cash. If the dividend is paid by cash, it is recorded as net reduction in the accounts and books. Since cash dividends reduce the amount of liquid assets owned by the company, its asset value is reduced in the balance sheet. If a company has a great deal of retained earnings, it shows that it’s doing well. How it utilizes those earnings can have a positive impact on shareholders, in the form of dividends, or on the company itself, in terms of further investment for business expansion.
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