Paid-In Capital
It is important to keep paid-in capital separate from earned capital (retained earnings) because they are two different forms of capital. For the investor, it is important to understand the differences between the two. Paid-in capital is the capital that the stockholders have paid into the business. Earned capital is the capital that has accumulated from the firm's earnings (Kieso, Weygandt and Warfield, 2007). Thus, the latter is a measure of how much money the firm has made while the former is a measure of how much money the firm has raised.
It is important to keep these two forms of capital separate because they derive from two different activities. On the cash flow statement, for example, paid-in capital would be a financing cash flow while earned capital would be a combination of operating and investing flows. By maintaining a clear distinction between the two, the exact nature of the firm's capital structure can better be determined. This allows for more accurate evaluation of the firm's financial condition.
On the balance sheet, the different forms of assets, liabilities and equity are all kept separate. This facilities financial evaluation, and gives a more accurate portrayal of the company's financial circumstances. The two major forms of equity represent two entirely different activities and two entirely different types of financing. For investors and other stakeholders, understanding how much of the company's equity comes from its profits is important, perhaps more important than understanding how much money the company is able to raise on the capital markets.
2. For the investor, it is likely that earned capital is more important. To understand the primary reason for this, the objective of the investor must be understood....
The simplest understanding of the objective of investors is that they want to earn a return on their investment. Paid-in capital is not representative in any way of return. It simply accounts for the money that has been put into the firm by the stockholders. Indeed, for the average investor any growth in paid-in capital would likely represent a dilution of the value his or her own equity holding.
Earned capital, on the other hand, derives from the firm's earnings, net of any dividend payments. When a firm does not have earnings, it does not record earned capital. Therefore, earned capital is essentially the cumulative earnings of the firm that have been reinvested in the firm. For the investor, this is the more valuable of the two pieces of information. The firm's earnings, when plowed back into the firm, represent an increase in the book value of the firm's equity. This increase in the book value comes without an increase in the number of shares. Therefore, it represents an increase in the book value per share of the firm's equity -- an increase in the value of the investor's stock. The more the firm's equity grows without additional paid-in capital, the more valuable the firm's stock is both in terms of book value and probably in terms of market value as well.
Therefore, the investor will want to track the growth in the value of the retained earnings or earned capital. The growth in this line item will reflect on the overall financial performance of the company, especially its profitability and the determination of management to plow earnings back into growth. For the investor, tracking the changes in earned capital allows for not only an assessment of the firm's profitability but of management's assessment of the firm's future prospects. When management believes…
