AFM Assignment 2 - BY THE

‘Royal Achievers’

Topic – Retained Earning

Submitted to-Mr. Gurdeepak Singh

Introduction

When sizing up a company's fundamentals, investors need to look at how much capital is kept from shareholder Making profits for shareholders ought to be the main objective for a listed companies and, as such, investors tend to pay most attention to reported profits. Sure, profits are important. But what the company does with that money is equally important.

Typically, a portion of the profit is distributed to shareholders in the form of a dividend. What gets left over is called Retained Earning or retained capital. Savvy investors should look closely at how a company puts retained capital to use and generates a return on it.

Retained earning is a balance sheet account and is presented in the equity section.
Retained earnings are an account that accumulates or the revenues and expenses from the day of establishment of the company.

Retained earnings, also known as retained surplus, are the portion of a company's profits that it keeps to reinvest in the business or pay off debt, rather than paying them out as dividends to its investors.

Retained earnings are one component of the corporation's net worth and increase the supply of cash that's available for acquisitions, repurchase of outstanding shares, or other expenditures the board of directors authorizes.

Smaller and faster-growing companies tend to have a high ratio of retained earnings to fuel research and development plus new product expansion. Mature firms, on the other hand, tend to pay out a higher percentage of their profits as dividends

Discussion

Now let us now discuss about

· Job of retained earning

· Retained earning for growth

· Determining the return on retained earning

· Evaluating Retained Earnings by Market Value

Job of retained earning

In broad terms, capital retained is used to maintain existing operations or to increase sales and profits by growing the business.

Life can be hard for some companies - such as those in manufacturing - that have to spend a large chunk of profits on new plants and equipment just to maintain existing operations. Decent returns for even the most patient investors can be elusive. For those forced to constantly repair and replace costly machinery, retained capital tends to be slim.

Some companies need large amounts of new capital just to keep running. Others, however, can use the capital to grow. When you invest in a company, you should make it your priority to know how much capital the company appears to need and whether management has a track record of providing shareholders with a good return on that capital.

Retained Earnings for Growth
If it has any chance of growing, a company must be able to retain earnings and invest them in business ventures that, in turn, can generate more earnings. In other words, a company that aims to grow must be able to put its money to work, just like any investor. Say you earn $10,000 each year and put it away in a cookie jar on top of your refrigerator. You will have $100,000 after 10 years. However, if you earn $10,000 and invest it in a stock earning 10% compounded annually, then you will have $159,000 after 10 years.

Retained earnings should boost company value and, in turn, boost the value of the amount of money you invest into it. The trouble is that most companies use their retained earnings for maintaining the status quo. If a company can use its retained earnings to produce above-average returns, then it is better off keeping those earnings instead of paying them out to shareholders.

Determining the Return on Retained Earnings

Fortunately, for companies with at least several years of historical performance, there is a fairly simple way to gauge how well management employs retained capital. Simply compare the total amount of profit per share retained by a company over a given period of time against the change in profit per share over that same period of time.

For example, if Company A earns 25 cents a share in 1993 and $1.35 a share in 2003, then per-share earnings rose by $1.10. From 1993 through 2003, Company A earned a total of $7.50 per share. Of the $7.50, Company A paid out $2 in dividends, and therefore had a retained earnings of $5.50 a share. Since the company's earnings per share in 2003 is $1.35, we know the $5.50 in retained earnings produced $1.10 in additional income for 2003. Company A's management earned a return of 20% ($1.10 divided by $5.50) in 2003 on the $5.50 a share in retained earnings.

When evaluating the return on retained earnings, you need to determine whether it's worth it for a company to keep its profits. If a company reinvests retained capital and doesn't enjoy significant growth, investors would probably be better served if the board of directors declared a dividend.

Evaluating Retained Earnings by Market Value

Another way to evaluate the effectiveness of management in its use of retained capital is to measure how much market value has been added by the company's retention of capital. Suppose shares of Company A were trading at $10 in 1993, and in 2003 they traded at $20. Thus, $5.50 cents per share of retained capital produced $10 per share of increased market value. In other words, for every $1 retained by management, $1.82 ($10 divided by $5.50) of market value was created. Impressive market value gains mean that investors can trust management to extract value from capital retained by the business.

Conclusion

In the end of retained earning we think that for stable companies with long operating histories, measuring the ability of management to employ retained capital profitably is relatively straightforward. Before buying, investors need to ask themselves not only whether a company can make profits, but whether management can be trusted to generate growth with those profits.

Submitted by:

Shilpa Chandni M.B.A 1 (C)

Prabhjot Singh M.B.A 1(B)

Malkeet Singh Saggu M.B.A 1(A)