In answering the following questions there was a struggle to distinguish paid-in capital and earned capital. When it comes to basic or diluted earnings per share while the issue can become a little confusing, it was simple to distinguish between the two. The following questions will be answered, explain why it is important to keep paid-in capital separate from earned capital, explain why paid-in capital or earned capital is more important to an investor, and finally as an investor, are basic or diluted earnings per share more important?
Why is it important to keep paid-in capital separate from earned capital? Paid-in capital is when a company issues stock to investors, in return the company receives capital. According to Paid in Capital vs. Earned Capital (1997-20012), “Earned capital is also called retained earnings, earned capital is the portion of net income that companies choose not to distribute as dividends. ” Paid-in capital represents the shareholders investments, and earned capital comes from profits made by the company’s operations.
Keeping these two capitals separate is important to show profitability from company operations. A company can have a profitable year because of investments from stockholders, but can be in the negative from operations. By separating them it gives investors a true picture of how the company is actually doing. As an investor, is paid-in capital or earned capital more important? Whether a company has the ability to generate a constant profitability weighs heavily on whether an investor will invest money into a company.
Keeping in mind earned capital comes from profit made by operations, an investor will look towards this information to determine if a company has the ability to generate profit. The earned capital is also used to pay dividends in cash as well as stock. Paid-in capital is only excess over the par value which is fixed and does not contribute to the dividends paid to investors. This makes the earned capital more important to investors than paid-in capital. As an investor, are basic or diluted earnings per share more important?
As an investor diluted earnings would preferred over basic earnings. Basic earnings are the same as earnings per share of common stock. According to Kieso, Weygant, & Warfield (2010), “basic earnings are calculated by dividing the net income available to the common stock shareholders by weighted average number of shares which are outstanding at the time. ” While diluted earnings are one step above the basic earnings. Diluted earnings are calculated on the assumption that all convertible securities have been exercised.
Basic earnings are calculated considering only common stock currently in existence. Diluted earnings represent the earnings a common shareholder would receive in a worst case scenario. According to Wall Street Words: An A to Z Guide to Investment, “Diluted earnings per share are a particularly effective method of presenting earnings-per-share data for companies with complex capital structures. ” When an investor is about to invest into a company knowing the worst case scenario would give the investor the lowest return they would make.
This would allow the investor to know how much is too much to pay for a stock. Investors are always looking to know which company will have the best return. Knowing why paid-in capital and earned capital needs to be separate, allows the investor to have an understanding of what to look at when trying to decide what company to invest in. After understanding paid-in capital and earned capital and investor will understand earned capital is more important to them.
Earned capital gives the investor the picture of how a company is operating financially. Finally, an investor should look at and understand basic earnings and diluted earnings. This is where an investor will see what the worst case scenario for their investment will be. By analyzing a company’s diluted earnings, an investor will see what their shares will return in dividends if all convertible securities are exercised. Doing homework on companies in which one would like to invest in can have big returns.
Part of this homework is knowing what to look at, and what is important.
Kieso, D. E. , Weygandt, J. J. , & Warfield, T. D. (2010). Intermediate Accounting, (13th ed. ). Hoboken, NJ: John Wiley & Sons. Paid in Capital vs. Earned Capital. (1997 -2012). Retrieved from http://budgeting. thenest. com/paid-capital-vs-earned-capital-26802. html Wall Street Words: An A to Z Guide to Investment Terms for Today’s Investor by David L. Scott. (2003). Published by Houghton Mifflin Company.