Some companies make it a practice to utilize retained earnings to finance their various projects, besides managing financial requirements pertaining to fixed and working capital. At the very outset, it must be noted that, for financing purposes, only existing companies can take recourse to this method. New business undertakings cannot avail of the advantages of this method. Established concerns do not employ it, when there is a problem of immediate financing of a major programme.
The peculiar feature of retained earnings is that, contrary to their methods, they are an internal source of finance. They arise from the profit which is not distributed among shareholders. As a result, no long-term debt is incurred, and ownership, by way of the sale of voting stock, is not diluted.
A proper utilization of retained earnings has the advantage of avoiding the cost of investment that would have been incurred if bonds or stocks were sold to public. There is conclusive proof of the fact that firms which build up its surplus accounts by withholding dividends if stockholders are in a better position to face adverse business conditions than other firms.
Apart from successfully established big businesses, a small business, too, can tap this source of finance for its expansion and development programme.
However, ploughing back of profit should be resorted to with great caution, for excessive ploughing back is detrimental not only to the interests of the shareholders but also to corporate management at large.
From the financial point of view, the profit earned during a financial year is channelized in
- The government shares in profit through income tax;
- The amount payable to stockholders as cash dividends;
- The amount to be retained,
The disposition of the profit through income tax is determined by tax laws. However, with regard to dividends and retention of profit, the management has to take a decision, for there is a close relationship between the dividend paid and the profits retained. If the dividend rate is higher, the amount of retained earnings is bound to be small.