Investors often buy shares of stock in a company without even looking at its financial statements. However, even a quick skim of those corporate financials can tell you a lot about both where a business has been, and where it's going. For instance, a company's balance sheet can tell you not just about the assets and liabilities that it has, but also the retained earnings it has held onto throughout its history.
Assets, liabilities, and stockholder equity
One of the most basic relationships in the balance sheet is that of assets, liabilities, and stockholder equity. As its name implies, the balance sheet must be in balance. To do so, the amount of assets on the company's books has to be equal to the sum of the company's liabilities and its stockholder equity.
You can divide each of these main categories into smaller subcategories. For instance, on the asset side of the balance sheet, you'll often find line items for cash, accounts receivable, and other current assets, as well as fixed assets like intangibles and property, plant, and equipment. Liabilities include current items like accounts payable, as well as long-term debt and other longer-lived obligations.
On the stockholder equity side, you'll find two main categories. The first includes contributed capital, which typically appears in the common stock line item. The second takes the form of retained earnings, representing money that the company has made in income during its history, and chosen to hold onto rather than paying it out in dividends.
Calculating retained earnings
The balance sheet will usually tell you directly what the retained earnings of the company are, but even if it doesn't, you can calculate it from other figures. Specifically, you can follow a two-step process:
- Look at the total amount of assets and liabilities of the company. When you subtract liabilities from assets, what's left is stockholder equity.
- Look at the common stock line item on the balance sheet. If you know that the only two items in stockholder equity are common stock and retained earnings, then just take the total stockholder equity and subtract the common stock line item figure. The difference is the retained earnings.
Some companies have more complex balance sheets that include additional line items and numbers. The key, though, is understanding that you can calculate unknown numbers by taking the numbers you do know, and using basic math to fill in the blanks. Doing so can give you a clearer picture of the situation a company faces, and whether it would make a good investment.
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