How To Differentiate Between Capital Stock and Retained Earnings

The foundation for all forms of accounting is one basic formula, Assets=Liabilities + Stockholder's Equity.  The stockholder's equity section is comprised of both capital stock and retained earnings.  Capital stock is all of the stock, both preferred and common, that a company has available to issue.  Once this stock is purchased,  stockholders have invested and now own a part or percentage of the business.  All of the profits made by the business can either be paid to the stockholders which are called dividends, or the money can be saved in an account called Retained Earnings.

Basically Retained Earnings consists of net profit that is kept in the business.  This is usually kept within the business to invest in other areas that can create more opportunities for the company.  On the other hand Capital stick is not kept within the company.  This is generally the original capital paid into the business by those that created it.  A predetermined amount of shares are made available for shareholders to acquire a percentage of the company.  These shares of stock allow others to literally own part of the company, meanings they not only collect profits but are part of the decision making too.

When you look at Retained Earnings on the balance sheet under Stockholder's Equity, you can gain insight to a company.  When a company keeps all net profit within a business and does not pay out dividends to it shareholders, then it could be a sign that the company is in financial trouble.  If the company cannot afford to pay out the dividends  which would be more beneficial to its shareholders then its possible that doing so could send them into bankruptcy. The company is more than likely using all of its profits to maintain and if nothing changes then bankruptcy is likely.

Capital stock on the balance sheet however shows how much stock is available in the business.  This can be useful in showing how much capital the company has available.  This can show how well off a company is and how much potential the company may have.  It also serves as a safety net for creditors, the more capital available the less likely a company is to default on any debt.  However, if the company lacks sufficient capital or more capital then liabilities then it could be a sign that there is not sufficient capital support the company.  This could be a sign of a bad investment.


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