Difference Between Common Stock and Retained Earnings

Common Stock, as the name suggests, is the most general (common) type of stock. It is a primary form of ownership showing a claim on the part of the company's assets and earnings. If you are a shareholder in a company, it does not mean that you are the master of the company's physical properties, like a chair and computer. The company, a unique legal entity, owns these things. Shareholder in the company means that you own a residual claim in the corporation's profit and assets.

Difference Between Common Stock and Retained Earnings

Retained Earnings refer to a part of earnings or profit that cannot shared with the shareholders as part of dividends. This capital is reinvested in the business towards working capital requirements and for buying physical fixed assets. This capital can also be used to pay any debt obligations. Retained earnings are shown in balance sheets.

Common Stocks

Common stocks can be defined as securities that indicate individual ownership in a designated corporation and their claim on the ventured accrued profits. Such stocks allow stockholders the power to elect the company's board of directors and voting rights to interfere in corporate policies.

Difference Between Common Stock and Retained Earnings

Generally, common shares are believed to produce high returns over the long term. Common stockholders receive dividend income, which is distributed after preference shareholders have been compensated with accrued profits.

In case of bankruptcy, creditors, preference shareholders, and bondholders are given priority in giving their shares to those who have invested in the stocks of the company. Common stockholders are typically entitled to receive any remaining assets after other stockholders, such as creditors and preference shareholders, have been paid accordingly. These stocks are often issued to the public through an initial public offering (IPO).

Rationale Behind Issuing Common Stocks

Generally, Common stock is issued as an alternative option for disposing of debt bonds or issuing preference stock. The primary objective behind issuing common stocks is to raise capital.

Capital is raised for various purposes that could include:

  • Paying Off Debts
  • Establishing Cash Reserve for a future period
  • Acquisition of a promising company
  • Expansion

Usually, common stocks are issued in the market to weaken the holding power of active stockholders. Hence, Company owners generally approach issuing shares with caution, carefully considering all the merits and demerits before making a last-minute decision.

Characteristics of Common Stocks

Characteristics of the common stocks include Stock Rights, Investment Options, and Returns. Briefly, all of these characteristics have been discussed below:

  1. Stock Rights
    Common Stocks tend to transfer certain rights to the stockholders. For example, the individual who has invested in a corporation is entitled to have the following rights:
    • Voting Rights: The stockholder has the power to elect the board of directors of the company
    • Dividend Right: Entitled to receive dividends
    • Assets Rights: Entitled to receive any remaining assets in the event of liquidation
    • Pre-emptive rights: Entitled to get consideration
  2. Investment Options
    These are the following ways in which investors can invest their money:
    • Via Stock Exchange
    • Investing in a mutual fund
    • Via direct stock plan
    • Through a dividend reinvestment plan
  3. Returns
    A common stock allows its investors to earn earnings in two ways: dividend income and capital gains. Investors have more chances to receive higher capital gains when the company's stock value increases. Likewise, suppose the company retains a large portion of its revenues after spending on maintenance and charges and other miscellaneous expenses. In that case, it may give this as a dividend to the investors.

Benefits of the Common Stocks

Several benefits are attached to the common Stocks. The following are benefits that come with the common stocks:

  • Potential Profits: Performance-wise, common stocks are known for giving higher returns compared to deposit certificates, bonds, and other investment avenues. Also, there is no limit to which investors can benefit from their investment in common stock shares. Also, Common stocks are more feasible and cheaper compared to debt instruments. Companies do not have to pay interest to their investors and may opt to reward excessive profits.
  • Voting Rights: Each investor is allotted one voting right per share of common stock possessed. However, these rights are subject to company policies and participation in business decisions. For example, an investor may get the right to elect the company's board of directors through its voting right or may participate in the company's strategic policy decision. Investors holding significant common stock can exercise most of the power in the company.
  • Limited Legal Liabilities: Since they are passive holders, their obligations to common stock investors are limited in nature. They do not have to worry about events occurring beyond their financial investment. Moreover, such stocks offer a secure financial future if a company is generating significant returns and seeing steady growth. Investors are also insulated from the risk of losing more of what they have invested. All of these factors favor investors making the most of the growth aspects of common stocks without getting involved in unwarranted legal hurdles.
  • Liquidity: Common stocks are liquid, and therefore, investors can easily invest in or surrender them. It assists investors in purchasing more shares and expanding their stake in a company. Likewise, they can smoothly surrender their investment if it is not proving profitable. Moreover, this type of shares can also be sold at decent prices without any hassles, making it a viable investment opportunity.

Demerits of Common Stocks

  • Profits are Risky: Market forces heavily influence revenue generation, and income is not guaranteed. Uncertainties dominate such stock options, and profit is not assured. It is one of the limiting factors for those people who have invested in the common stocks by looking at its growth potential.
  • Market-Related Risk: Common stock prices are heavily influenced by market volatility; therefore, they often never remain steady. During performance evaluation, stock values dramatically change unexpectedly, making the process challenging. During bankruptcy, the common stockholders face more heat since they lose all their investments.
  • Loose Control: Generating profits from common stock investments relies on business strategies and associated policies, which suggests investors need more influence in the formation of these strategies and policies. Furthermore, investors lack the right to participate in policymaking sessions or scrutinize the company's accounting books or business plans, which limits their influence.

Qualities Required to be Potential Investors in Common Stocks

Difference Between Common Stock and Retained Earnings

Due to the tremendous risk associated with the common stocks, therefore, it is not suited for individuals who are risk averse. Stock prices also tend to fluctuate based on market volatility. However, with all these disadvantages, the common stocks hold a large growth potential and investors can extract maximum out of it by parking their funds in stock baskets for the long term. Therefore, it is a fabulous opportunity for those who are willing to take big risks and have a great investment horizon. These stocks would be viable for them.

Retained Earnings

Retained Earnings are accrued parts of business profits that are not distributed as dividends but are kept for reinvestment in the business. These earnings are usually used for working capital and fixed asset purchases. They can also be used to pay off debt obligations. At the end of each accounting period, Retained Earnings are marked on the balance sheets in the shareholder's equity section.

Rationale Behind Retained Earnings

Retained Earnings show a useful line between the income statement and balance sheet as they are maintained under the shareholder's equity, which links the two statements. The purpose of retaining these earnings could be different, and it includes purchasing new machines, investing in research and development, or miscellaneous activities that may boost the company's growth. These reinvestments are done to double the earnings in the future.

If the company thinks that it can earn enough return on investment from those retained earnings, then it will share those earnings with shareholders as dividends or exercise a share buyback.

The formula for the Retained Earnings

Difference Between Common Stock and Retained Earnings

The cost of retained earnings must be considered as the opportunity cost of the foregone dividends. From the point of view of equity shareholders, any earnings retained by the firm could have been profitably invested by the equity shareholders- ers themselves, had these been distributed to them. Thus, there is an opportunity cost involved in the firms retaining the earnings and an estimation of this cost can be taken up as a measure of cost of capital of retained earnings, k,.

The cost of retained earnings, k, is often taken as equal to the cost of equity share capital, k, since the retained earnings are viewed as the fresh subscription to the equity share capital. Suppose a firm has to decide whether to raise funds by issuing new equity shares or by retaining the earnings. In that case, it will have to find out the rate of return at which the investors will be indifferent between whether the firm distributes the earnings or reinvests these earnings for future growth. It is reflected in the market price of the share, which is used to determine the cost of equity. If the investors are not getting the expected returns from the firm's reinvestment, they will tend to sell their holdings, forcing down the price until they get the expected return. By lowering the share price, the investors maintain the required rate of returns. Therefore, the share price fully reflects the cost of capital of the retained earnings. So, k=k. The cost of retained earnings is not to be adjusted for tax, flotation cost, and underpricing. While retaining the earnings, the firm does not in any way incur any such cost, and the earnings to be retained are already after tax.

Key Features of Retained Earning

There are several key features attached to the retained earnings, and they are:

  • Flotation Cost: Compared to other sources of financing, retained earnings allow one to avoid issue-related costs.
  • Zero Cost: One crucial and significant feature of retained earnings is that it is a zero-cost financing option for the company. The company is insulated from paying interest, which usually happens when a firm tries to raise capital through borrowings.
  • Legal Liability: The use of retained earnings is not subject to legal scrutiny. The company must pass a resolution in the annual general meeting.

Advantages of Retained Earnings

  • It is a continuous source of funds for a firm
  • Devoid of Explicit Costs such as dividends, interests, or dividends
  • Retained earnings generated internally, therefore, give freedom and flexibility to the firm for the usage
  • It gives the upper hand to absorb and recover in case of massive losses

Disadvantages of Retained Earnings

  • Retained earning is not a stable source of financing since it a lot depends on the profitability of a firm.
  • It may become a source of dissatisfaction among shareholders, as excessive retained earnings may result in a low dividend distribution.

Difference Between Common Stocks and Retained Earnings

AspectsCommon StocksRetained Earnings
DefinitionIt shows ownership of the firm or corporationAccrued profits are reserved with the company
Source of FundsFunds are raised by issuing shares to the publicIt is accrued from the net profit over time
OwnershipShareholders are given voting rights in the companyNo such case of rights involved in the retained earnings
PurposeThe main objective behind the issue of shares is to raise funds to continue their business management.The primary motive behind keeping some portion of the profit is reinvestment or boosting the growth of the company.
FormulaCommon stock value can be calculated as Nominal Value per share * Number of shares or Common Stock = Total Equity - Retained EarningsRetained Earnings values can be calculated as:Retained Earnings = Beginnings Retained Earnings + Net Income or Loss - Dividends

Conclusion

Common Stocks and retained earnings are a firm's source of financing and an important component of its financial structure. They are established to serve distinct purposes and represent different facets of shareholding equity.

Common stocks endow the shareholder with the voting right and also signify ownership in the firm and serve as instruments for investment and capital raising. On the other side, the retained earnings are an internal source of financing and give more space to the management of the company. It shows the company's ability to generate profit over the period contributing to its financial stability and growth. Understanding the difference between common stocks and retained earnings is crucial for the investor and they have a massive influence in shaping the firm's financial and growth prospects.






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