Retained Earnings, Short-Term Sources for Working Capital
Retained Earnings (RE) are the portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations.
Retained Earnings are reported on the balance sheet under the shareholder’s equity section at the end of each accounting period. To calculate RE, the beginning RE balance is added to the net income or loss and then dividend payouts are subtracted. A summary report called a statement of retained earnings is also maintained, outlining the changes in RE for a specific period.
The Purpose of Retained Earnings
Retained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity which connects the two statements. The purpose of retaining these earnings can be varied and includes buying new equipment and machines, spending on research and development, or other activities that could potentially generate growth for the company. This reinvestment into the company aims to achieve even more earnings in the future.
If a company does not believe it can earn a sufficient return on investment from those retained earnings (i.e., earn more than their cost of capital) then they will often distribute those earnings to shareholders as dividends or share buybacks.
What is the Retained Earnings Formula?
The RE formula is as follows:
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Where RE = Retained Earnings
At the end of each accounting period, retained earnings are reported on the balance sheet as the accumulated income from the prior year (including the current year’s income), minus dividends paid to shareholders. In the next accounting cycle, the RE ending balance from the previous accounting period will now become the retained earnings beginning balance.
The RE balance may not always be a positive number as it may reflect that the current period’s net loss is greater than that of the RE beginning balance. Alternatively, a large distribution of dividends that exceed the retained earnings balance can cause it to go negative.
How Net Income Impacts Retained Earnings
Any changes or movement with net income will directly impact the RE balance. Factors such as an increase or decrease in net income and incurrence of net loss will pave the way to either business profitability or deficit. The Retained Earnings account can be negative due to large, cumulative net losses. Naturally, the same items that effect net income effect RE.
Examples of these items include sales revenue, cost of goods sold, depreciation, and other operating expenses. Non-cash items such as write-downs or impairments and stock-based compensation also affect the account.
Short-Term Sources for Working Capital
# 1. Indigenous Bankers:
Private money-lenders and other country bankers used to be the only source of finance prior to the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to the largest extent possible. Now-a-days with the development of commercial banks they have lost their monopoly.
But even today some business houses have to depend upon indigenous bankers for obtaining loans to meet their working capital requirements.
# 2. Trade Credit:
Trade credit refers to the credit extended by the suppliers of goods in the normal course of business. As present day commerce is built upon credit, the trade credit arrangement of a firm with its suppliers is an important source of short-term finance.
The credit-worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit. It is mostly granted on an open account basis whereby supplier sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. It may also take the form of bills payable whereby the buyer signs a bill of exchange payable on a specified future date.
When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called stretching accounts payable. A firm may generate additional short-term finances by stretching accounts payable, but it may have to pay penal interest charges as well as to forgo cash discount. If a firm delays the payment frequently, it adversely affects the credit worthiness of the firm and it may not be allowed such credit facilities in future.
The main advantages of trade credit as a source of short-term finance include:
(i) It is an easy and convenient method of finance.
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is informal and spontaneous source of finance.
However, the biggest disadvantage of this method of finance is charging of higher prices by the suppliers and loss of cash discount.
# 3. Installment Credit:
This is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in installments over a pre-determined period of time. Generally, interest is charged on the unpaid price or it may be adjusted in the price. But, in any case, it provides funds for some time and is used as a source of short-term working capital by many business houses which have difficult fund position.
# 4. Advances:
Some business houses get advances from their customers and agents against orders and this source is a short-term source of finance for them. It is a cheap source of finance and in order to minimize their investment in working capital, some firms having long production cycle, specially the firms manufacturing industrial products prefer to take advances from their customers.
#5. Factoring or Accounts Receivable Credit:
Another method of raising short-term finance is through accounts receivable credit offered by commercial banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its customers.
Thus, a firm gets immediate payment for sales made on credit. A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales. Factoring is becoming popular all over the world on account of various services offered by the institutions engaged in it.
Factors render services varying from bill discounting facilities offered by commercial banks to a total takeover of administration of credit sales including maintenance of sales ledger, collection of accounts receivables, credit control and protection from bad debts, provision of finance and rendering of advisory services to their clients. Factoring may be on a recourse basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.
At present, factoring in India is rendered by only a few financial institutions on a recourse basis. However, the Report of the Working Group on Money Market (Vaghul Committee) constituted by the Reserve
Bank of India has recommended that banks should be encouraged to set up factoring divisions to provide speedy finance to the corporate entities.
In-spite of many services offered by factoring, it suffers from certain limitations. The most critical fall outs of factoring include;
(i) The high cost of factoring as compared to other sources of short-term finance,
(ii) The perception of financial weakness about the firm availing factoring services, and
(iii) Adverse impact of tough stance taken by factor, against a defaulting buyer, upon the borrower resulting into reduced future sales.
#6. Accrued Expenses:
Accrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also. These simply represent a liability that a firm has to pay for the services already received by it. The most important items of accruals are wages and salaries, interest, and taxes.
Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services already rendered by employees. The longer the payment-period, the greater is the amount of liability towards employees or the funds provided by them. In the same manner, accrued interest and taxes also constitute a short-term source of finance.
Taxes are paid after collection and in the intervening period serve as a good source of finance. Even income-tax is paid periodically much after the profits have been earned. Like taxes, interest is also paid periodically while the funds are used continuously by a firm. Thus, all accrued expenses can be used as a source of finance.
The amount of accruals varies with the change in the level of activity of a firm. When the activity level expands, accruals also increase and hence they provide a spontaneous source of finance. Further, as no interest is payable on accrued expenses, they represent a free source of financing.
However, it must be noted that it may not be desirable or even possible to postpone these expenses for a long period. The payment period of wages and salaries is determined by provisions of law and practice in industry.
Similarly, the payment dates of taxes are governed by law and delays may attract penalties. Thus, we may conclude that frequency and magnitude of accruals is beyond the control of managements. Even then, they serve as a spontaneous, interest free, limited source of short-term financing.
#7. Deferred Incomes:
Deferred incomes are incomes received in advance before supplying goods or services. They represent funds received by a firm for which it has to supply goods or services in future. These funds increase the liquidity of a firm and constitute an important source of short-term finance. However, firms having great demand for its products and services, and those having good reputation in the market can demand deferred incomes.
#8. Commercial Paper:
Commercial paper represents unsecured promissory notes issued by firms to raise short-term funds. It is an important money market instrument in advanced countries like U.S.A. In India, the Reserve Bank of India introduced commercial paper in the Indian money market on the recommendations of the Working Group on Money Market (Vaghul Committee).
But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short-term funds. The Reserve Bank of India has laid down a number of conditions to determine eligibility of a company for the issue of commercial paper. Only a company which is listed on the stock exchange, has a net worth of at least Rs 10 crores and a maximum permissible bank finance of Rs 25 crores can issue commercial paper not exceeding 30 per cent of its working capital limit.
The maturity period of commercial paper, in India, mostly ranges from 91 to 180 days. It is sold at a discount from its face value and redeemed at face value on its maturity. Hence, the cost of raising funds, through this source, is a function of the amount of discount and the period of maturity and no interest rate is provided by the Reserve Bank of India for this purpose.
Commercial paper is usually bought by investors including banks, insurance companies, unit trusts and firms to invest surplus funds for a short-period. A credit rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers.
Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit and proves to be effective even during period of tight bank credit. However, it can be used as a source of finance only by large companies enjoying high credit rating and sound financial health. Another disadvantage of commercial paper is that it cannot be redeemed before the maturity date even if the issuing firm has surplus funds to pay back.
#9. Working Capital Finance by Commercial Banks:
Commercial banks are the most important source of short-term capital. The major portion of working capital loans are provided by commercial banks. They provide a wide variety of loans tailored to meet the specific requirements of a concern.
The different forms in which the banks normally provide loans and advances are as follows:
(b) Cash Credits
(d) Purchasing and discounting of bills.