Difference Between Common Stock and Retained EarningsCommon 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. 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 StocksCommon 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. 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 StocksGenerally, 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:
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 StocksCharacteristics of the common stocks include Stock Rights, Investment Options, and Returns. Briefly, all of these characteristics have been discussed below:
Benefits of the Common StocksSeveral benefits are attached to the common Stocks. The following are benefits that come with the common stocks:
Demerits of Common Stocks
Qualities Required to be Potential Investors in Common StocksDue 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 EarningsRetained 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 EarningsRetained 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 EarningsThe 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 EarningThere are several key features attached to the retained earnings, and they are:
Advantages of Retained Earnings
Disadvantages of Retained Earnings
Difference Between Common Stocks and Retained Earnings
ConclusionCommon 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. Next TopicDifference Between |