Many people who invest are confused about a common term on the balance sheet called retained earnings. Retained earnings are below equity and 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 this leaves only cash, but that is not entirely true. Retained earnings are simply money reinvested in the business to buy debt or liability reductions, or to buy more assets since the business started, causing the businesses’ retained earnings to increase. 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 surplus cash to pay shareholders for cash holdings of previous years. Now that you know that retained earnings are not cash but rather a RECORD of the money invested in the business, it is important to know where this money is going.
One of the ways to know 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 are investing in has left after one year. Common figures in 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 to the value of a cash asset, either on a balance sheet or on a cash flow sheet, a parenthesis will appear 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 money spent or lost on depreciating assets and money earned from investments, etc. Once you add them, you will notice that it equates to the most current year’s retained earnings if you are looking at your statements annually. Make sure the math is coming out right or the company could be doing the books, making mistakes, or doing something else somewhere on the balance sheet, income statement, or cash flow statement.
Okay, so then pretend that you have studied where the company you want to invest in is putting its money and now you need to verify its proportions. Suppose this company makes a million a year in net income, and they RETAIN half of that to pay off debts and buy assets, while the other half is paid to you as a dividend. You will soon want to know how well the company is investing this money. We have two important indices that generally show how well a company is managing its investments, called return on invested capital and return on assets. Your return on invested capital should be ABOVE the industry average and your return on assets should also be above the industry average. This will show you that the company is investing CASH correctly.