Page 296 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes

Did u know? What is surplus?

Surplus is the amount of profit remaining after tax and distribution to stockholders that is
retained in a business and used as a reserve or as a means of financing expansion or
investment.

When sizing up a company’s fundamentals, investors need to look at how much capital is kept
from shareholders. Making profits for shareholders ought to be the main objective for a listed
company and, as such, investors tend to pay most attention to reported profits. Sure, profits are
important. But what the company does with that money is equally important.

Typically, a portion of the profit is distributed to shareholders in the form of a dividend. What
gets left over is called retained earnings or retained capital. Savvy investors should look closely
at how a company puts retained capital to use and generates a return on it.

It is sometimes rather loosely stated in management texts and business journals that ‘retained
profits are reinvested in the assets of the company’ or that ‘profits are ploughed back’, thus
giving management a reasonably cheap and easily accessible source of funds to finance growth.
These ‘internally generated funds’ are easily accessible provided a company makes good profits,
because directors can, within limits, choose dividend levels. They can choose to retain and use
(reinvest) the resulting increase in company assets. The funds are also cheap because there are no
costs involved in issuing more shares and no borrowing costs. What this really means is that the
managers of profitable businesses have more assets to use in productive activities.

Sometimes companies will convert part of retained profits into permanent share capital by
issuing bonus shares to existing shareholders, free of any cash contribution (because the increase
in assets from profit making has already been received). From a company viewpoint bonus
shares have no effect on financing or investing activities
The ability to use retained earnings wisely is a sign of good company management. If the
company management cannot do any better with earnings than he can, then he is better off if the
company pays him the full amount in dividends.

In broad terms, capital retained is used to maintain existing operations or to increase sales and
profits by growing the business.
Some companies need large amounts of new capital just to keep running. Others, however, can
use the capital to grow. When you invest in a company, you should make it your priority to
know how much capital the company appears to need and whether management has a track
record of providing shareholders with a good return on that capital.
Fortunately, for companies with at least several years of historical performance, there is a fairly
simple way to gauge how well management employs retained capital. Simply compare the total
amount of profit per share retained by a company over a given period of time against the change
in profit per share over that same period of time.

!
Caution When evaluating the return on retained earnings, you need to determine whether
it’s worth it for a company to keep its profits. If a company reinvests retained capital and
doesn’t enjoy significant growth, investors would probably be better served if the board
of directors declared a dividend.

Another way to evaluate the effectiveness of management in its use of retained capital is to
measure how much market value has been added by the company’s retention of capital. Suppose
shares of Company A were trading at 10 in 1993, and in 2003 they traded at 20. Thus,

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