Stockholders’ equity, also called book value, is the company’s assets minus its liabilities. When we value investors discuss shareholders’ equity, we are talking about tangible book value. But what happens if a company has negative retained earnings, such that it drives the shareholder’s equity negative? Does this happen?
Quick answer, you bet!
Last week we discussed the statement of retained earnings, which makes up contents of this statement, as well as retained earnings.
To review, the accounting equation for shareholders’ equity is:
Shareholders’ equity = Assets – Liabilities
If the retained earnings are negative, it could drive the shareholders’ equity negative, and this could lead to bankruptcy. Is that always the case? Not necessarily, as we will see.
There are some very public, large companies that have negative retained earnings such as most recently Starbucks. The problem with shareholder equity on the balance sheet is that there is no distinction made between capital that owners put into the business and capital that the business produced itself and retained.
In today’s post, we will discuss:
- What are negative retained earnings?
- How to locate negative retained earnings
- The impact of negative retained earnings
- Can you pay dividends with negative retained earnings?
What Are Negative Retained Earnings?
If you recall retained earnings from last week’s post are the balance leftover from net income that is set aside for dividends, share repurchases, or reinvestment back into the company.
So what are negative retained earnings?
Negative retained earnings would be the result of a negative net income and then is subtracted from any balance in retained earnings from prior financial reports, i.e., 10q or 10k.
Negative retained earnings could result in negative shareholders’ equity if the company has sustained losses for a sustained period.
If the event of sustained negative retained earnings could erode monies received from sales of stock, all in all, not a good situation to be in at any time.
Additional causes of negative retained earnings, besides negative net income:
- Large dividend payments: payments that exhausted retained earnings or went above the balance of shareholder’s equity. Continued large dividend payments over several periods could lead to negative retained earnings.
- Borrowing money: If the company borrows large amounts of money to cover accumulated losses instead of issuing more shares through equity funding could lead to negative retained earnings. Typically, with the sale of more shares, the monies would lead to a positive balance in shareholders’ equity. If the company continued with financial losses in shareholders’ equity, then any incurred would show as a liability. So even if a company borrowed funds to cover the losses the shareholders’ equity would still be negative.
Negative shareholders’ equity could be a warning sign that a company is in financial duress, because this would mean that they have spent all of their retained earnings, and exhausted the means of raising funds from the sale of shares.
More on this in a moment.
Where to Find Negative Retained Earnings?
Negative retained earnings will be able to be found on both the balance sheet and the statement of retained earnings, as they are linked.
Let’s take a look at a real company’s financials to get an idea of how to find negative retained earnings.
First, we are going to look at Starbucks (SBUX), who reported their annual report, or 10-k in September 2019.
The first report we will look at is the statement of retained earnings.
As we look deeper into Starbucks, you can see that the resulting balance on September 29, 2019, was negative $6,231 million.
Several things I would like to point out to you are:
- Earnings over the two years have seen a downward trend; this is something to notice over a longer period because such a small sample size of two years is not enough to say anything with certainty.
- The dividends paid by Starbucks have been fairly consistent over this two-year snapshot
- The share repurchases have been increasingly aggressive, which has resulted in the retained earnings going negative. With the decrease in net income and aggressive share repurchases, the retained earnings have turned negative.
The first question I would want to answer if I wanted to invest in Starbucks would be to find out why they have been so aggressive with the share repurchases? Are they funding other aspects of the business with debt, or is there some other reason driving this decision?
Remember that one of the ways we can determine the quality of management and their views on shareholder value is to decipher the retained earnings and what management does with them.
Let’s look at Starbucks’ balance sheet to get an idea of how negative retained earnings could affect the overall company.
Again, a few things I would like to point out as we dive into Starbucks’ balance sheet.
- Retained earnings are negative, $5,771.2 million, and Total Shareholders’ equity is negative $6,232.2 million, which means that total equity is negative.
- The negative shareholder equity lowers the total liabilities and equity, which in turn increases the total liabilities.
- As balance sheets must balance, the negative shareholders’ equity, which increases the liabilities in relation to the total assets.
- Notice that total liabilities have increased compared to total assets decreasing that is never a good place to be, with more liabilities than assets. What that means is that you potentially owe more than you own, and that can be very precarious. Because if something bad happens, you may not be able to recover.
When investigating any company, these are all part of the due diligence process that we must go through to determine if we want to invest in this company.
In Starbucks’ case, the question I would ask is? Would any answer you determine be enough to overcome the imbalance of the liabilities versus assets? My thought is that this would fall into the too hard pile, and I would move on. Investing is a difficult endeavor and sometimes it is ok to move on from an idea. It doesn’t mean that the company is bad or that it is a mistake to investigate; it might mean that right now is not a good time to buy this particular company.
Let’s look at another company’s’ retained earnings, Snapchat (SNAP). Snapchat’s’ balance sheet from December 2019 shows an accumulated loss, although the shareholders’ equity is still positive.
Let’s take a look.
We can see from Snapchat’s balance sheet that they are experiencing continued growth of their accumulated deficit, which stems from the company’s continued losses in their net income. The additional paid-in capital that you see above that line is from additional sales of shares, which dilutes ownership.
Every company has a story to tell through their numbers; our job is to try to decipher what the numbers are trying to tell us. My favorite finance teacher, Dr. Aswath Damodaran, talks about the stories that the numbers are trying to tell us and how we can interpret them.
In Snapchat’s case, they are telling me that this company is struggling to grow its revenue enough to overcome their expenses, as their bottom line is continuing to be negative. The continuation of negative net income at some point is unsustainable and could cause problems going forward.
For me, investing in Snapchat at this point in their development is not a company I would buy, I am not saying that the product is bad, or that the company is flawed in some way. What I am saying is that for my risk tolerance and what I look for in companies to invest, they are not my cup of tea, and I would pass after noticing the continued losses.
Growth Companies and Negative Earnings
One of the items that you will notice is that companies like Facebook, Netflix, Google, in their early years, were companies that experienced losses from their bottom line. In other words, they were not profitable companies on their own.
If you look at some of their early annual reports, you will see negative retained earnings through the early years, but they were able to show positive shareholders’ equity through the strength of selling shares of the company to create capital to use to fund the business.
They were able to use the strength of their brand to help them keep going until they were profitable. Not all companies can do this and depend on where they are in the life cycle; this could spell trouble if they are not able to drive sales for the business.
The last example I would like to share with you is Sears (SHLD), one of the more recent large companies to file for bankruptcy.
It should be plain as day for anyone looking that Sears was in serious trouble when looking at their balance sheet. It shows ongoing negative deficits in retained earnings and negative shareholders’ equity.
All this spelled trouble for Sears; with their shrinking margins and declining revenue, they were not able to sustain themselves. This is what separates company’s like Facebook and Netflix from Sears in that they have been able to grow revenues to the point where they have been able to sustain the company past the point of selling shares to keep themselves afloat.
Can a Company with Negative Retained Earnings Pay a Dividend?
Andrew and I talk continuously about the importance of dividends and how they play a very important role in our, and millions of others, investing goals.
Heck, even Warren Buffett, in his latest shareholder letter, spoke on the importance of dividends to his portfolio and how they contributed some much to their ongoing pile of cash.
Many investors rely on dividends for their income and the double compounding effect they can have on the growth of our investment portfolios.
So what happens when a company has negative retained earnings, or they are losing money?
Many companies aren’t allowed to pay dividends if they are losing money, and they have no retained earnings, except under special circumstances.
Many investors find it confusing that companies can pay a dividend, even when they are losing money. The main reason this is possible is that when a company retains earnings from a previous period, they are reserving the right to pay those out as a dividend, or share repurchase, or other ways to reinvest in the business.
When a new startup comes out of the gate, they typically lose money from the start, so they are not able to build up their retained earnings to be able to pay a dividend or reinvest back into the business.
Once the company stabilizes or becomes more mature, then they would have the retained earnings built up enough to pay out a dividend.
One question that pops into my mind is it legal to pay out a dividend when the company has negative retained earnings or a net income loss?
The answer is yes, they are allowed to, but is it prudent to do so? That is not for me to answer, per se.
When considering decisions based on balance sheet investigations, we have to remember that the balance sheet is a snapshot in time, and not necessarily what is transpiring with the company at that moment.
Think of companies, like dividend aristocrats; they have built a shareholder base that expects them to pay a growing dividend every single year and sometimes, based on the balance sheet, that may not be possible.
For example, when a company goes through a cyclical change that causes a downturn in net earnings, this could show on the balance sheet as a decrease in retained earnings, or there might not be enough cash to grow the retained earnings, but the company might decide to “eat” into their savings so to speak to keep the dividend payment going.
Let’s say, for example, that the company has ample cash and marketable securities on the balance sheet, along with good operating cash flow; then, it makes sense that they would be able to continue to pay a dividend.
Always remember that GAAP net income is subject to many non-cash adjustments, where operating cash flow is a fact.
I want to circle back a moment to discuss a company that is not growing its retained earnings but still paying a dividend. Johnson & Johnson in their latest 10-k showed an annual payout of growing dividends and share repurchases, but if you look closer, you see their retained earnings decreased from the previous year.
Not every year, are you going to see a growth in retained earnings, as evidenced by Johnson & Johnson.
Notice that over the last two years, their retained earnings have declined year to year.
One way that a company can continue to pay dividends even with negative net earnings or a negative retained earnings for the year is through loans.
One company, in particular, who has utilized this approach lately is Chevron (CVX). Chevron has paid a growing dividend for over 32 years and is a charter member of the Dividend Aristocrats.
For 2015, Chevron’s dividend payout ratio was over 100%, typically a payout ratio over 50% is considered high. So how was this possible?
In Chevron’s case, they have had to borrow money to the tune of $2 billion a quarter to fund the dividend. They had already cut their capital expenditures to zero, cut share repurchases, sell assets, and trimmed administrative expenses as much as they could.
Does this mean that Chevron is going bankrupt? Not at all, but what it does signal is that the company is struggling financially, and the only way to attract investors is to entice them with a growing dividend. With the price of oil continually forced down and the demand around the world low, the price looks to be depressed ongoing. Chevron is doing what it needs to do to continue to attract investors while trying to struggle through a downturn in a cyclical business.
Let’s take some numbers for a second. Currently, Chevron is earnings $1.51 TTM, with the current dividends being paid at $4.46 per share, with a dividend yield of 4.46%.
So logically, if Chevron is only earning $1.51 a share and they have to pay their dividend out of earnings, but they are paying $4.46 per share for the dividend, then where is the money coming from?
It can come from a variety of sources; first would be retained earnings. Or in Chevron’s case, they are borrowing short-term monies to pay for the dividend in the hopes that they will be able to pay the money back on time.
Another note to make mention of is that Chevron’s current PE ratio is 72! Talk about overvalued, jeesh.
Does this mean that Chevron is going under? Nope, but what it does mean that we have to be vigilant with any company that we buy and that we must do our due diligence and check the financials at least once a year, if not quarterly, to make sure they are on track.
Chevron is in a commodity business and they are going to have ups and downs during the life of their business, and there is always the possibility that the commodity they deal with could eventually be replaced with the various types of electrical power that have been gaining more traction such as solar power, electric cars, wind power and so on.
Chevron is not alone in this trend, among others are Exxon Mobil, Verizon, and many more.
These are all trends that we must be aware of, and by reading the financials regularly, we can keep informed on the life of our businesses.
Negative retained earnings are the status of any company that might enter from time to time. Is this a complete death knell for the company?
Sometimes yes, sometimes no. One of the aspects to keep in mind is where the company is in its life cycle.
Say the company is brand new, just has gone public, then it is expected for them to carrying negative retained earnings because they are probably losing money at this point in their growth.
As the company matures, then it is reasonable to expect them to climb out of the negative retained earnings status and become a grown-up company.
If the company is experiencing continued negative retained earnings because of a steady drop in the revenue, then it is time to pause, and possibly run very far away from the company, because they have hit the point of no return.
As always, we must explore and investigate every company that we buy and do our due diligence to ensure we are buying an outstanding business.
As always, thank you for taking the time to read this post and I hope you find something of use in your investing journey.
If I can be of any further help, please don’t hesitate to reach out.