What is Retained Earnings?
Net income of a company has two elements: Dividend and Retained earnings. After paying dividend to the shareholder, a portion of income is kept by the hand of corporation, this portion of profit is called retained earnings.
It is a source of internal financing. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities.
Under the retained earnings sources of finance, a part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
Advantages of Retained Earnings
Retained earnings consist of the following important advantages:
- Useful for expansion and diversification: Retained earnings are most useful to expansion and diversification of the business activities.
- Economical sources of finance: Retained earnings are one of the least costly sources of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different types of securities.
- No fixed obligation: If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest.
- Flexible sources: Retained earnings allow the financial structure to remain completely flexible. The company need not raise loans for further requirements, if it has retained earnings.
- Increase the share value: When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance; Hence the value of the share will increase.
- Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.
- Increase earning capacity: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:
- Misuses: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.
- Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.
- Over capitalization: Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance.
- Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.
- Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.