Table of Contents
- What is Ploughing Back of Profits?
- Merits of Internal Financing
- Determinants of Internal Savings
- Dangers of Ploughing Back of Profits
- Retained earnings as source of financing
What is Ploughing Back of Profits?
A new enterprise should acquire its initial capital from the external sources only. But the initial capital alone is not sufficient for any business enterprises. Further, investment is inevitable for expansion and improvement. It is not worthwhile for any reasonable management to depend solely on external sources for subsequent development of the enterprise. The business enterprise should try to stand on their own legs rather than depending on others.
In other words, savings or retained earnings should be utilized for these purposes. The corporate enterprises should not distribute all of its profits earned during the prosperous periods but should retain a sizable portion of the profit by following a conservative dividend policy. The utilization of such undistributed profit for meeting all of the financial requirements is known as “Self financing” or “Financing from internal resources“.
It is an ideal method of financing, as it raises no problems or complications associated with external sources of finance. Moreover, such retained earnings can be used with greatest advantage. It will also enable the business firms to escape the crushing effects of depression however severe it may be. This process is technically termed as “Ploughing back of profits“.
Merits of Internal Financing
The practice of ploughing back of profits of internal financing has several merits over external financing. The various advantages of internal financing can be viewed from three angles viz.,
- Advantages to Company.
- Advantages to Shareholders.
- Advantages to the Society.
1. Advantages of Internal financing to the Company
1. The company can withstand seasonal reactions and business fluctuations. The retained profits act as a cushion to absorb the shocks of depression and dull business conditions.
2. Large accumulated profit shall enable the company to follow a stable dividend policy. This will enhance the credit standing of the company.
3. It constitutes an important source of finance without creating any charge over the assets of the company.
4. The operating efficiency of the enterprise shall not decrease because the deficiencies of depreciation, depletion and obsolescence can be recouped internally.
5. It can be used to discharge the long-term liabilities and redeem debentures.
1. The enhanced credit standing of the company shall enable the shareholders to have a ready and continuous market for their holdings.
2. The market value of the share shall go up and the investor can take advantage of this.
3. The shareholders shall also get an increased rate of return in the form of higher dividend, bonus shares etc.
4. The securities enjoy a high collateral value. Hence, they can furnish them as securities for obtaining loans and advances. The bankers will also consider such shares and debentures as a reliable security.
3. Advantages of Internal financing to the Society
1. Retained earnings increase the rate of capital formation, which is essential for the economic prosperity of the nation.
2. Corporate savings enable the smooth and continuous functioning of the companies. This keeps the industrial morality at a higher level. Chances for failure of the industrial units and their consequent closure are minimized.
3. The productivity of the industry as a whole will increase. The ultimate benefit will go to the society. The consumers can use more goods and avail more services at a cheaper cost. This in turn will lead to a fair standard of living.
Determinants of Internal Savings
The volume of retained profit is influenced by many factors. Particularly, there are three factors upon which the volume of accumulated earning depends. They are:
- Corporate Earnings,
- Taxation Policy of the Government, and
- Dividend Policy of a Company.
1. Corporate Earnings determines Internal Savings
The question of retaining the earnings will arise only when there is enough net profit. The volume of profit in turn depends upon many factors. If the profit is not stable or subject to frequent fluctuations, the volume of retained earnings shall also be little.
2. Taxation Policy of the Government determines Internal Savings
The Government taxation policy also affects the volume of retained profits considerably. Particularly in our country, every company should pay at least 40% of its net profit as income tax. Only with remaining amount, the companies have to declare a fair rate of dividend and pay a bonus to the employees etc. All these factors reduce the volume of retained earnings considerably.
3. Dividend Policy determines Internal Savings
The dividend policy followed by the company also determines the extent to which profits can be retained for ploughing back.
If the company follows a liberal dividend policy, it cannot retain much of its profits. But if the company follows a conservative policy, it can retain much profit at the same time it can also maintain a stable rate of dividend.
As a rule, every company must establish a fair rate of dividend, which can be maintained under all conditions of earnings. Some suggested a statutory limitation of the dividends.
In 1974, the Government of India made an attempt to fix a ceiling on the dividend rate. According to the Companies (Temporary Restriction on Dividend) Act, 1974, no company could pay a dividend in excess of one third of the net profits of the company or 12% of the face value of the shares whichever was lower.
But this restriction was lifted in the next year itself i.e. in march 1975. However, it is now provided that every company before declaring any dividend should transfer a certain percentage not exceeding 100% of the net profit to the reserves of the company. Various percentages are fixed by the Central Government according to the rate of dividend declared.
Dangers of Ploughing Back of Profits
Internal financing may not always be useful to the company or its shareholders. This practice may prove dangerous if excessive ploughing back of profits is carried on. The following are the drawbacks or dangers associated with the policy of indiscriminate ploughing back.
1. Growth of Monopoly Power
If ploughing back of profit is continuously carried on, it may result in monopoly and concentration of wealth and power in the hands of a few. New concerns at the same time shall find it difficult to raise sufficient capital they need.
2. Speculative Activities
Excessive reserves shall enable the management to manipulate the accounts and thereby involve in speculative dealings. Such dealings will artificially create violent fluctuations in the share price movements. This will ultimately affect the interest of
the ignorant investors.
3. Denial of the Right
Withholding a large portion of the profit shall amount to a gross denial of the right in the assets of the company in which the shareholders have a legitimate right.
4. Evils of Over Capitalization
The accumulated reserves may result in over capitalization of the company. Consequently, the company should face the dangers of over capitalization.
5. Misuse of Funds
Excessive savings may be misused against the interest of the shareholders. The management may lock them up in their pet concerns or companies under the same management.
6. Social Waste
It may lead to a social waste in the sense that it interferes with the freedom of the investors and function of the capital market. The result is that the money is not made available to those who can utilize it to the best advantage of the community. It is really an interference with inherent rights of the investors.
Retained earnings though subject to certain drawbacks still constitute an ideal and viable source of finance. This method is very popular in U.S.A. However, the Government should regulate internal financing with a view to maintain a proper balance between the old and new enterprises. Viable projects should not be allowed to go unimplemented due to lack of funds.
Retained earnings as source of financing
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 three directions:
- 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.