Shareholders equity is an essential part of the accounting equation: Shareholders Equity = Total Assets – Total Liabilities. It is the difference between the value of a company’s assets and liabilities. This does not mean that every company has a shareholders equity account with money in it, yet it does mean that every business has this account on the balance sheet. This is because shareholders equity comes from the shareholders’ investments into the business and from retained earnings. In new companies, a large portion of this equity comes from the owners’ initial investments. In a more mature-stage company, retained earnings is often the majority of shareholders equity on the balance sheet.
Retained earnings is one of the two components that make up Shareholders Equity. It is simply the net income that a business does not distribute to its shareholders. This account is listed underneath Shareholders Equity and is closed out after each period.
As mentioned, dividends are taken out of net income before going into the retained earnings account. The decision to pay dividends is affected by taxes and the required reinvestment for the next period. Distributing less or more affects a company’s taxes as well as the shareholders’ taxes. By paying out large dividends, a company can minimize its takes due. This transfers the tax liability to the shareholders. Keeping net income to reinvest into the business also has tax implications. Holding onto cash rather than paying dividends results in higher taxes.
Return on equity (ROE) is a term to describe net income as a percentage of shareholders equity. In other words, return on equity is net income / shareholders equity. This percentage shows how efficient a company is at using shareholders equity to create a profit. When looking at a company, examining its return on equity over the last several years can show the true growth of a company. ROE is a fast indicator of sustainable growth, since net profit is the ‘organic’ way to reinvest into a company. For this reason, many refer to ROE as the sustainable growth rate.
Calling return on investment sustainable growth rate is helpful in planning cash needs. If a business has a ROE of 10%, then it knows that it can reinvest and grow 10% that year without outside investment. This can be very helpful for investors. If an entrepreneur shows a business plan with a projected 30% annual growth, sustaining a 15% ROE, and has no plans for outside investment, then he or she will inevitably have cash flow problems. Additional funds make up the disparity between the 15% and 30%. Being cognizant of a business’s sustainable growth rate helps plan for future cash flow problems. After all, underestimating cash needs is one of the top reasons for businesses that fail.