The Real Value of Retained Earnings

Picture it: Your client is getting a divorce. You’ve worked tirelessly to identify and value the marital estate. Just one problem, your client owns a business. You haven’t yet engaged a financial expert, but you get an offer from opposing counsel: “We don’t need to get a valuation, let’s just split the retained earnings.” This sentiment would make most accountants wince, because retained earnings and value aren’t the same thing.

Retained Earnings vs. Business Value

As valuation experts, we are all too used to hearing people equate retained earnings to value. We hear it from attorneys, arbitrators, judges and even some accountants. It’s an understandable assumption. There’s a number right there on the balance sheet that tells us how much the business kept, so that must be how much it’s worth. Right?

In most cases, no.

The term retained earnings is somewhat of a misnomer. The retained earnings of a business are “retained,” and they are “earnings,” but it’s not like they just sit in a bank account (at least, not usually). Think about it this way: Company A sells widgets. Company A sells enough widgets to make a profit. The owners of Company A then face a choice. Profit can be paid out to the owners or left in the Company. Company A elects to keep the money in the business, which makes it retained earnings. Company A then elects to buy another widget-making machine so that next year, they have even more profits. That transaction looks a bit like this:

Even though this is a simplified example, the idea remains the same, no matter the size. If company profits aren’t distributed, they are typically reinvested into the business. The money that isn’t distributed is the retained earnings. But that doesn’t mean it is sitting in a cash account. Most of the time, retained earnings are used to buy new assets or fund the operations.

Depending on how those funds were used, the retained earnings balance could drastically overstate or understate the value of the business.

Take Company A, for example: The machine they buy turns out to be a dud. It can only produce half as many widgets as it is meant to. Because it can’t make as many widgets, the value of that machine goes down. The company still earned that profit, still kept the earnings in the business, still used them to buy equipment, but now the equipment is worth less while the retained earnings stay the same. In this case, the retained earnings overstate the value of the Company and relying on the retained earnings balance as the value would be unfair to your client.

So, then, if the retained earnings aren’t sitting in cash, where are they?

How Retained Earnings Are Used and What They Really Mean

To understand that, we need to take a quick step back and learn some accounting—stay with me.

To start, retained earnings are an integral part of “double-entry” accounting. Double-entry accounting is the name for the general base of accounting we use. Double-entry accounting simply means that every entry is recorded in at least two accounts on offsetting sides of the “accounting equation”. This means that at the end of the period, the Company’s books will equal each other (balance).

The accounting equation is as follows:

Assets = Liabilities + Equity

This is the simplest form of this equation, but from a valuation standpoint, we often look at this equation slightly differently. Generally, equity is what the company is worth, so we tend to think of the accounting equation as:

Equity = Assets – Liabilities

The equity side of the accounting equation can then be broken down further into the following:

Retained Earnings + Capital (Partners Capital or Stock) = Assets – Liabilities

Retained earnings can then be broken down even further into:

Beginning Retained Earnings + Net Income – Dividends (Distributions) + Capital = Assets – Liabilities

Notably, retained earnings are only a part of the total equity value. Retained earnings are simply the numerical representation of previous earnings. Basically, it’s just an accounting item.

So, let’s recap. What does this show us?

Retained earnings are an accounting calculation that tracks historical earnings, but they don’t give the whole picture. There are other accounts that impact the total business value that aren’t included in retained earnings. Additionally, retained earnings are recorded at “cost” and don’t reflect changes in the market value of assets.

When Is a Full Business Valuation Needed

All this is well and good, but what happens when you inevitably get the next offer to use the retained earnings as the business value? What do you do? How can you quickly tell if the offer to split the retained earnings is fair?

Well, without really digging into the underlying financial information, you couldn’t be certain, but if the business has a single employee, has no assets besides cash and has enough cash to cover the retained earnings, then the retained earnings balance could be a valid method of valuing the business. Other than in this specific instance though, the retained earnings are generally a poor indicator of total business value.

So, then what do you do? Do you have to get a full valuation every time a business is involved? Unfortunately, there is no simple answer. Business valuation is specific to the individual business being valued. The facts and circumstances surrounding each business heavily impact the value. If you are ever unsure, the best course of action is to talk with a valuation professional. We’re always happy to advise you on whether a settlement offer is fair or if a full valuation might be necessary. There isn’t always a need for a full valuation, but even we can’t tell without knowing some of the specifics of the business and looking at some of the financials.

Need help evaluating a settlement offer or determining what a business is really worth? Contact CBIZ Valuation professionals to talk through the facts and get clear, defensible guidance.