Shareholders’ total equity represents two major components as retained earnings and Paid-In Capital. Other Equity contributors are Treasury stocks and other Reserves. For a sole proprietorship business or a limited partnership for a small business, both represent the same components.
The fact that a sole proprietor or a small partnership comes with unlimited business liability makes the retained earnings and Paid-In capital liable towards the owner(s).
For large companies and quoted firms though the Paid-In capital represents the resources invested in the business. The invested resources than generate profits that are paid back to investors in the form of dividends and capital gains. As such, both Paid-In capital and retained earnings make up for the shareholders’ total wealth.
Retained Earnings as Owner’s Equity Portion:
Any company’s prime objective is to maximize shareholders’ wealth. Retained earnings are the portion of Net Income that a business retains for the reinvestment in business operations.
Retained earnings are net proceeds from the company revenue after paying out taxes, adjusting depreciation and interest costs. In other words, retained earnings represent the undistributed profits or Dividend for the shareholders. Hence, retained earnings represent the owners’ equity.
Retained earnings represent any changes in net profits and losses over time less the dividends paid to the shareholders.
Ending Retained Earnings= Beginning Retained Earnings + Profits (Loss) – Dividends
Or simply from the Income Statement as:
Retained Earnings = Net Profits – Dividends
Paid-In Capital in the Owners’ Equity Portion:
Retained earnings are net proceeds from the business operations through capital employed by investors. The Paid-in capital can be raised through Initial Public offering as common or preferred stocks.
The shares issued are denominated at book value or at par and the issue price is set close to the share market price.
The Paid-In capital then comprises of contributed capital and additional paid-in capital or the Share Premium. Paid-in capital also represents the owners’ equity portion at book value.
Since both Retained Earnings and Paid-In capital are recorded at book values. Combined they represent the total book value of a company.
Company’s Book Value = Paid-In Capital + Retained Earnings
Investors’ Perspective with Paid-In Capital and Retained Earnings:
When Investors put their money in any company they expect returns against the risk. For Equity or Stocks investment the rate or cost of equity determines the expected rate of return.
However, when a company generates net profits, it can either distribute the profits to the shareholders as dividends or retain for reinvestments. In other words, retained earnings cause shareholders an opportunity cost of foregoing dividends.
Thus, shareholders will expect the company to generate profits at least at the rate of the cost of equity. Reinvested capital also returns higher shareholders’ equity through price appreciation.
Another perspective is the rate of capital employed or the efficiency of a company’s capital utilization to generate profits. The shareholders will be interested in how well a company is generating returns on their invested capital.
The Dividend Decision:
It represents simply a company managements’ perspective about splitting the profits as dividends and keeping the cash for reinvestments. Dividends can be paid out of retained earnings (or borrowed finances due to lack of cash), it reduces the book value of shareholders’ total equity.
Shareholders’ though expect dividends if the company has surplus cash. A large sum of retained earnings also means a company’s inability to reinvest in positive cash flow projects.
Investors will also be keen in dividend payout ratios that indicate the amount of net profits distributed and retained. A too high or too low dividend ratio will be disliked by the investors.
For example, if a company retained 90% of profits and pays 10% in dividends, it may not be enough for cash dividend expectations for shareholders. Contrarily, a too high dividend ratio above 50% will also make future funding options risky, as large firms often face cash deficit.
Retained Earnings’ Effect on Paid-In Capital:
The company management retains profits as it offers a cheap source of funding to them. If they pay out all profits generated in dividends, they’ll have to borrow expensive funds to continue business operations.
Thus, a higher cost of capital will result in lower future profits and lower retained earnings for the business. In other words, without an optimal balance between retained earnings and dividends the company’s performance will suffer.
Shareholders’ equity with increased borrowings (liabilities) may result in negative total equity for the shareholders. Also, the total cost of capital will be higher due to increased bank borrowings and/or equity funding.
The Bottom Line:
Retained Earnings and Paid-In Capital form the total book value of shareholders’ equity. The Paid-In Capital represents the invested resources by shareholders’ in the form of contributed capital and shares premium. Retained earnings denominate the utilization of these resources to generate profits.