The importance of retained earnings for a successful investment: retained earnings are not cash

Many people who invest get confused by a common balance sheet term called retained earnings. Retained earnings go below shareholder equity and ARE NOT cash. Many people think of retained earnings as cash because the formula for retained earnings is net income minus dividends paid. People think that this leaves only cash, but that is not true at all. Retained earnings are simply the money reinvested in the business to pay down debt, reduce liabilities, or buy more assets since the business started, which increases the business’ retained earnings. The only way retained earnings can decrease is if there is a negative supply of net income, or if more dividends are paid than net income, that is, the company uses the leftover cash to pay shareholders for the cash holdings of previous years. Now that you know that retained earnings is not cash but a RECORD of money invested in the business, it’s important to know where this money is going.

One of the ways to tell if a company is using money wisely is to look at the cash flow statement. Since cash is king, it’s important to know how much cash the business you’re investing in has left after one year. Common figures on an income statement are cash flow from operations, cash flow from investing, and cash flow from financing. All of these numbers show you whether or not there was a net increase or decrease in each of these top three things companies do. If there is a net decrease in the value of an asset in cash, either on a balance sheet or on a cash flow sheet, it will appear in parentheses around the figure, and if it is an increase, it will appear normal. The cash flow statement is more accurate than just looking at earnings because it shows money spent or lost on depreciation of assets and money earned from investments, etc. To verify that the books are correct, subtract dividends paid from net income above, and then add the figure you get to prior years’ retained earnings. You’ll notice once you add them in that it equals the most current years retained earnings if you’re looking at the statements annually. Make sure the math is right, or the company could be tampering with the books, making mistakes, or doing something else somewhere on the balance sheet, income statement, or cash flow statement.

Okay, pretend you’ve studied where the company you want to invest in is putting its money and now you need to check their ratios. He claims this company makes $1 million a year in net income, and he HOLDS half of that to pay off debt and buy assets, while the other half is paid to him as a dividend. Soon you will want to know how well the company is investing this money. We have two important ratios that generally show how well a company is managing its investments, called return on invested capital and return on assets. The return on invested capital must be ABOVE the industry average along with the return on assets above the industry average as well. This will show you that the company is investing CASH correctly.