The term retained earnings to stockholder's equity refers to a measure that allows the investor-analyst to understand if a company is retaining earnings to fund its growth or returning them to shareholders. The retained earnings to stockholder's equity ratio is of particular interest if company ownership is closely held by a small number of shareholders.
Retained Earnings to Stockholder's Equity = Retained Earnings / Total Stockholder's Equity
Capital structure and solvency measures allow the investor-analyst to understand the company's ability to remain in business in the long term. This is usually assessed by examining the relationship between debt, equity and the proportions of different types of stock. Solvency is the ability to continue operating, which oftentimes depends on cash flow. One of the ways to understand the capital structure of a company is by calculating their retained earnings to stockholder's equity ratio.
The retained earnings to stockholder's equity ratio allows the investor-analyst to understand if a company is returning earnings to shareholders or retaining them to fund the business's growth. This metric is especially important to understand if the company is closely held by relatively few individuals and is returning a relatively large proportion of earnings to those same shareholders in the form of a stock dividend. When a company returns earnings to shareholders in the form of dividends, it must pay for capital purchases with other sources of funding. Retained earnings are one of the least expensive forms of capital funding, so acquiring funds from other sources adds to the cost of running the business.
The manager of a large mutual fund would like to better understand Company ABC's cost of capital. The manager has a concern the company is returning dividends to shareholders instead of using those funds on capital purchases. Company ABC is closely held by relatively few individuals and the fund manager believes the company's dividend payout policy is allowing those owners to receive dividends at the expense of the remaining shareholders since capital purchase will need to be funded with more expensive sources. He asked his team to review the balance sheet of Company ABC's most recent annual report. The team found the following: total stockholder's equity $37,500,000 and retained earnings of $5,625,000. The retained earnings to stockholder's equity ratio would then be:
= $5,625,000 / $37,500,000, or 15.0%
The analysts compared this value to an industry average, which they found was 14.7%. Given this finding, the mutual fund manager was satisfied Company ABC's dividend payout policy was not being affected by individual shareholders.