Reserves and Surplus

Extract From My Book “Psychology And Investment” 

Take a look at reserves and surplus of the company on the balance sheet. If the reserves are strong and it is increasing every year then it provides a signal of strong health of the company. 

After declaring the dividend, the balance amount is transferred to reserves and added under retained earnings. Without the availability of adequate funds, a company cannot go for expansion and cannot achieve the desired growth. Therefore, a young and aggressive company is always interested in increasing reserves and it may be possible that they may not take interest in declaring a dividend. A growing company is always interested in increasing its reserves and this is a strong indication of a growth stock.

Retained earnings come from the net profit minus the total amount of dividends, which belong to the shareholders. Therefore, an increase in reserves is beneficial for the shareholders.

Compare the company's reserves to the size of its equity capital. This type of company is a strong candidate for a bonus if equity capital is low and reserves are increasing every year.

A company should declare its bonus when its business is growing and there is a genuine demand for its shares among the shareholders. Post bonus, the company's equity base increases, proportionally stock price decreases and it encourages retail participation.

When a company announces bonuses unnecessarily or just for financial gimmicks, the demand-supply mismatch of shares leads to a fall in prices, and if the company is not able to expand the business, the demand for shares will not increase, and prices will not go up due to excess supply of shares. Such a move would become a nightmare for the shareholders who bought the stock only because of the bonus announcement.