Many people investing get confused about a common term on the balance sheet called retained earnings. Retained earnings go under the shareholders equity and they ARE NOT cash. Many people think that retained earnings are 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 into the business to buy off debt–liability reductions, or to purchase more assets since the company started both of which cause the companies retained earnings to go up.
The only way that retained earnings can go down is if there is a negative supply of net income, or if more dividends are paid then net income i.e. the company uses leftover cash to pay shareholders for previous years cash holdings. Now that you know that retained earnings are not cash but rather a RECORD for money invested in the company, it’s important to know where this money is going.
One of the ways to tell if a company is using money wisely is by looking at the cash flow statement. Since cash is king it is important to know how much cash the company you’re investing in has left after a year. The common figures on an income statement are Cash flow from operations, Cash flow from investing, and Cash flow from financing. All of these figures show you whether or not there was a net increase or decrease from each one of these three main things that companies do. If there is a net decrease for a cash asset value, on either a balance sheet or a cash flow sheet it will show parentheses around the figure, and if it is an increase it will look normal.
The cash flow statement is more accurate than just looking at earnings because it shows you money spent or lost on depreciation of assets and money gained from investments etc… To check to make sure the books are correct subtract dividends paid from net income at the top, and then add the figure you get to the previous years retained earnings. You will notice once you add them that it equals the most current years retained earnings if you are looking at the statements annually. Make sure the math comes out right or the company could be cooking the books, making mistakes or doing something else somewhere on there balance sheet, income statement, or cash flow statement.
Okay so pretend you have studied where the company you want to invest in is putting its money and you now need to check its ratios. Pretend this company makes one million a year in net income, and they RETAIN half of that to pay on debt and to buy assets while the other half is paid to you as a dividend. You will soon want to know how well this money is being invested by the company.
We have two important ratios that generally show how well a company is handling its investments called return on invested capital and return on assets. The return on invested capital should be ABOVE the industry average along with its return on assets being above the industry average as well. This will show you that the company is investing CASH correctly.