Use of Company Profits
When a corporation makes a profit, it can spend that profit in two ways:
- return the profits to stockholders by way of dividends, share buy-backs or bonus issues;
- use the money to increase the profitability of the company
For example, a company makes a profit of $100. It can pay this entire amount to stockholders who can then use that money as they think fit – spend on consumer items, make further investments, whatever. Or the company can use all that profit to invest in the business with a view to increasing profits in future years. Or the company can do a bit of both.
Sign of strong management is good use of capital or retained earnings
The ability to use retained earnings wisely is a sign of good company management. If the company management cannot do any better with earnings than he can, then he is better off if the company pays him the full amount in dividends.
Warren Buffett on retained earnings
Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
Simple Test for Sufficient Use of Retained Earnings
A quick and dirty way to evaluate the use of retained earnings is to add the total value of profits retained and then use them to calculate the rate at which profits have increased from use of that money.
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