Cash Equivalents Vs. Retained Earnings

The balance sheet of a typical corporation has entries for "cash equivalents" listed under assets and "retained earnings" listed under stockholders' equity. Though both are good things to have, only one can buy the company a cup of coffee and a danish -- or anything else.

Cash Equivalents

As the name implies, a "cash equivalent" is something that's as good as cash. In accounting terms, this refers to short-term investments that a company can convert to cash quickly, usually within three months. That includes money-market accounts, commercial paper (essentially short-term loans to other companies) and highly liquid, easily sold securities such as U.S. Treasury bills. On most balance sheets, equivalents are lumped in with the actual cash in the company's bank accounts on a single line: "cash and equivalents."

Retained Earnings

Retained earnings is a running total of the company's profits and losses since the day it was founded. When a corporation posts a profit, it can do one of two things with it: return it to the shareholders as a dividend, or hold onto it to reinvest in the company. Any profits not paid out in dividends are "retained" by the company -- hence, the name retained earnings. So if a company has a $1 million profit and pays out $300,000 in dividends, retained earnings grows by $700,000. If the company loses $1 million, retained earnings falls by $1 million.

Retained Earnings Are Not Cash

If you learn one thing about retained earnings, let it be this: Just because a company has, say, $100 million in retained earnings, that doesn't mean the company has $100 million of available money on hand. Retained earnings represent past profits, and a big chunk of those profits are usually reinvested right back in the company. If a company spends $2 million on, say, a new factory, that doesn't affect the total balance of retained earnings. The $2 million is still retained by the company, but it's in the form of a factory rather than cash.

Cash Isn't Necessarily Spendable

Also be aware that the balance of cash and equivalents a company reports isn't necessarily available for spending on whatever tickles the CEO's fancy. That balance simply represents what's on hand and doesn't reveal whether it's spoken for. If the company has big expenses coming up, that money may already be committed. Comparing a company's cash position (its total cash and equivalents) to its current liabilities (its debts coming due soon) can help give you a sense of how much of that cash is truly mad money.

 

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