Balance Sheets: Equity vs. Retained Earnings

I’m a little confused about how Equity and Retained Earnings work. I just answered a QBank question that asked me to calculate ROE based on the balance sheet and income statement, where net income was 4127, common stock was 4000 and retained earnings was 4354. I would have thought that one just did (net income / common stock), but the correct calc is (net income / (stock + retained earnings)).

Can somone clarify Equity to me. I think what confuses me the most is why Equity is listed on a balance sheet in the first place. Isn’t just a calc of Assets - Liabilities? It doesn’t seem to exist concretely without these. I seems circular and redundant to need to show it on a balance sheet.

The way I’ve explained equity to myself is to think of it like my house and my mortgage. I have a $500K house, my mortgage is $400K, therefore I have $100K equity. I get that. But then how does the retained earning fit into that? Does the analogy flow that if I had rented a room (say for $4K a year) and had made $20K from that and not spent it, that would be retained earnings, so therefore the $100K of equity is $80K stock and $20K retained earnings shown on my balance sheet? So to calculate my ROE, I would do $4K / ($100K).

If the above is correct, what is the point of stripping out the retained earning from the stock on the balance sheet? Is it to display how much have come from initial investments vs. how many have come from earnings?

This is a simplified picture. When a company starts out – 100 Assets, financed by 80 debt . 20 Equity. = (100 - 80) Year 1 it does operations. During that time it made 20 in Net Income. (This is on the Income statement). This 20 is also Cash - which increases Assets. But Liabilities nothing changed - the Liabs are 80 still. So now A = L + E is out of whack temporarily… The Net Income now goes as Retained Earnings - (Part of the Equity bucket). So Equity becomes 40 and 120 - 80 = 40 – restores parity. The Retained Earnings is the balancing number between the Net Income and the Equity (between the Income Statement and the Balance sheet). Equity End = Equity Begin + Net Income (from Income Statement). Another way of saying the same thing… Balance sheet is a continuous picture of the company’s position. So it is cumulative. The Income statement is a single accounting period snapshot, and must be reconciled into the balance sheet. (Figures move on the balance sheet). and then the Income statement is again 0.

Assert = Capital + Liabilities (break even point for any business) Asserts < Capital + Liabilities (losses) Asserts > Capital + Liabilities (profitable situation) A firm owns money not only to creditors but also to its owners, that is why we equation asserts = Capital + Liabilities. If asserts are to be liquidated, value asserts should always be able to pay back money it owns owners and creditors. 1. Look at this way… Asserts are financed, by capital (Equity (owner’s/shareholders money) + Debt (long term loans)) 2. Liabilities (money owned to creditors, suppliers etc) is what company owns to creditors, banks etc. 3. Net Income which is calculated using in Income Statement. Can be given to equity shareholder in form of dividends or it can be ‘retained’ in business in form of retain earnings. Retain earning can be used in variety of ways, for instance, financing R and D project etc.

Return on Equity = Net Income / Shareholder Equity Shareholder Equity = Common Stock + Retained Earnings

So your Equity equals $120K = $100K (house 500 - mortgage 400) + $20K (you’ve earned and not spent) and your ROE is $4K / $120K.

Other equity considerations include things like distributions/dividends which have, for the most part, nothing to do with liabilities. To your point about Equity not really being needed, this is an example of something that isn’t the residual of an assets minus liability entry. It is strictly an assets (cash) and equity(shareholder dist/dividend) entry. And in this case it’s slightly unique because it’s a debit to equity when you might typically think as equity/equity accounts as being positive for the most part.

Simplified Case

Ending value of Equity = Opening Equity + Net Income - Dividends

Retained Earnings = NI - Dividends

I think the point of testing in the question was to first find the ending value of equity and then calculate ROE based on that.

RE is just undistributed earnings. Earnings increase the value of the firm (ie equity). If you always distribute all earnings then RE will be zero because you are distributing the earnings to the shareholders rather than increasing equity. If you never distribute earnings then RE will be equal to the sum of all prior period earnings and represent equity the shareholders have in the firm. The shareholders could demand a special dividend to take out some of that equity…and RE would be reduced.