The premise behind investing is that corporations operate to generate profits and increase shareholder wealth. Individuals and companies purchase shares in profitable companies to participate in this wealth increase. Knowing the relationship between retained earnings and shareholder's equity aids in understanding how this wealth increase occurs. When companies earn a profit and reinvest those profits, these retained earnings increase shareholder's equity.
Retained earnings are a direct link from a corporation's income statement to its balance sheet. Companies generate revenues and expenses, which result in either a net profit or a net loss, all shown on the income statement. At the beginning of the next accounting period (which, for public companies, is either one quarter or one year), that net profit or loss rolls over to the balance sheet into retained earnings. Most corporations record any dividends that the company distributes to shareholders as a reduction in retained earnings. The retained earnings that appear on the balance sheet are the accumulated net income or losses since the corporation's inception.
Shareholder's equity is sometimes referred to as net worth or capital. It typically appears at the bottom of a company's balance sheet. On the balance sheet, assets equal liabilities plus shareholder's equity. This means that a company's assets must balance with the total debt, obligations and equity the company has. Another viewpoint is that shareholder's equity is what remains if the corporation sells off all its assets and pays off all its liabilities. Any money that remains goes to the corporation's shareholders, who are the owners.
Shareholder's Equity Components
Shareholder's equity includes contributions and distributions. Shareholder's equity is the amount owners and investors paid for the corporation’s stock when it was issued plus any net profits since the company was founded less any net losses or dividend distributions since founding. The net profits or losses that are kept and not distributed are the retained earnings.
ABC Widget Corp. generated $65 million in net profit in the fiscal year that recently ended. The company didn't yet declare or issue any dividends for that fiscal year, nor did it issue any additional stock during the year. Consequently, ABC Widget's beginning year balance sheet now shows an increase in shareholder's equity of $65 million. The company's breakout of shareholder's equity shows that the increase was due solely to the $65 million in additional retained earnings.
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