The title of this post may be, to some of you, an obvious thing to say but you’d be surprised how many times in our training courses we hear people offer the view that a company could “use” its retained earnings for meeting future expenses.
Retained earnings are, I’m sure you know, part of shareholders’ equity on the balance sheet. Where things get a little murky for those not completely familiar with financial statements is what shareholders’ equity actually represents.
So, point one; everything under shareholders’ equity (sometimes just called “equity”) is a type of liability to the company – at some point in the future it will have to pay those funds to their rightful owners who are, in this case, the shareholders who have invested the funds in the company. It should go without saying (but I’m going to say it anyway) that a liability can’t be a savings fund that can be used to pay expenses – it’s already a liability.
Remember the accounting equation; assets equals equity plus liabilities.
The distinction between equity and liabilities is that equity is funds owed to “insiders”, that is, the shareholders, while liabilities are the funds owed to “outsiders” like trade creditors, banks etc.
Given what I just said about shareholders’ equity, it’s fairly obvious that whatever amount of equity that has been invested by the shareholders in the company is there to finance some of the assets on the other side of the equation (the rest of the assets are financed by the “outside” liabilities).
Which brings us to point two; if you want to know whether the company can pay its expenses, you need to look at the asset side of the balance sheet, not the equity and liabilities side.
Point three; shareholders’ equity can significantly reduce overnight. Yes, really.
If the shareholders want a dividend from the company, it doesn’t have to be paid from current profits, it can be paid from past profits which is what the retained earnings figure represents. If a dividend is paid from past profits, shareholders’ equity will have to reduce because the retained earnings figure will go down by the amount of the dividend.
Obviously, though, if you’re been paying attention you’ll know that a dividend can only be paid if there is cash available to pay it – which will be seen on the asset side of the balance sheet.
Finally, there is a way in which we can restrict the payment of dividends to shareholders in order to preserve the shareholders’ equity but that’s the subject of a future post.