Retained earnings is a component of equity, but it doesn’t necessarily mean that the company has any cash at all. So the correct answer to the question is …
Hey, everybody. This is Jason back in the Coach’s Hangout. Last week, we ended with a cliffhanger so let’s pull up the question and get after it. It says that ABC Corporation has $1 Million in retained earnings. Now, be honest, how many of you saw retained earnings and thought to yourselves it’s like cash or savings? Well, if the wording of the question got you thinking that way, then mission accomplished. It certainly made wrong answers A, B, and C, very compelling. Look, if you got tricked, that’s the whole point. Learning from your mistakes is a very powerful way to learn. To get the right answer, you need to have a good understanding of how the Statement of Financial Position works or at the very least be able to decipher a line or two in the textbook that hints at the answer.
The bottom line is, ‘retained earnings’ is a component of Equity, but it doesn’t necessarily mean that the company has any cash at all. So the correct answer to the question is D, ‘ABC Corporation may not be able to pay a cash dividend’. Now, if you got it right, congratulations! Stick around and I’ll share some helpful tips with you. But first, are you enjoying this Blog and the videos? If so, then go ahead and smash that Like button and subscribe to our YouTube channel. It helps with the algorithms and we really appreciate it. While you’re at it, maybe check out last week’s video and give my dad, Stu, a Like for making his YouTube debut. You’ll make his day. We’ll put a link to that video in the description below. The Statement of Financial Position is commonly referred to as a Balance Sheet, and I really liked that name because it tends to help a student understand and remember how it works.
Take a look at the simple Balance Sheet with very low numbers that I jot down whenever I tackle a Balance Sheet question. It keeps me from making any silly mistakes. Look at all the key points it reveals.
First of all, take note that unlike an income statement, which is over a certain period of time, the Balance Sheet is as of a specific date. On the left-hand side, we have assets, which in this case is $3. On the right-hand side, we have $2 in liabilities, which are basically debts that the company owes. Now, if the company has $3 in assets and $2 in liabilities, then the difference of $1 is considered equity. In other words, the company could liquidate its assets, pay back all of its debts, and still have $1 in equity remaining. Also, take note of the right-hand side of the Balance Sheet equals the left-hand side. In other words, both sides balance each other. You see why I love that name?
Jotting down this simple Balance Sheet may help you with other questions as well. For example, is it true that liabilities plus equity equals assets? And if you find the wording tricky, how about this? Does liabilities of $2 plus equities of $1 equal assets of $3? Well, you bet it does. Now, before we go any further, let’s do a couple quick exercises. We’re unpacking a lot here and I want to make sure everyone is still following along before we really get into retained earnings. Let’s assume that assets increased to $5 in liabilities are still only $2. What is the equity figure? Well, $5 in assets minus $2 in liabilities would equal $3 in equity. And notice the right-hand side and the left-hand side of this statement are still in balance. Let’s try one with bigger numbers. Instead of paying out dividends, the company decides to reinvest $1 million of net earnings back into the business to help grow the business. So its assets are now $1,000,005 and the liabilities are still only $2. So what would the correct equity figure be?
Well, $1,000,005 of assets minus liabilities of $2 means the equity would now be $1,000,003.
And if I asked you why the equity has gone up, your answer would probably be something like, “Well, the company retained its earnings within the business in order to grow it.” Here’s where the rubber hits the road. The consolidated Statement of Financial Position shown in the textbook doesn’t just provide the total equity figure, instead, it breaks down equity into three different components.
It may help to think of each component of equity as a description of where that equity comes from, their share capital, which is the capital the company received when it issued common and preferred shares. There’s non-controlling interest, but that’s beyond the scope of what I really want to talk about today. Finally, there’s retained earnings, which is the running total of earnings that the company’s reinvested or otherwise retained within the business since inception.
Now, the earnings that were retained may or may not still be sitting in cash. In fact, one could make a really good argument that it’d be foolish to have too much cash sitting by idly not earning a return of any kind. So your key takeaways are this. Number one, retained earnings is a component of equity. Number two, to know the company’s cash position you cannot look at the retainer earnings figure.
You have to check the cash and cash equivalents line on the Statement of Financial Position, which is listed under assets. So if we circle back to last week’s question, we can see the answer is definitely D, ABC Corporation may not be able to pay a cash dividend. Sometimes I like to end a cliffhanger video with another cliffhanger. Can the retained earnings figure go down or become negative? What do you think? Well, I’ll tell you what, if I can get 50 likes, I’ll cover it in a future video. Thanks for dropping by the Coach’s Hangout, and good luck with your upcoming exams.