It is regarded as the most dependable source of longterm finance. Retained earnings are an easy source of internal financing to use because they are readily available (provided company have profits).
Retained earnings are the portion of net income (profit after tax) that have retained in the company and not paid out to the shareholders as dividends. Instead of paying out retained earnings, shareholders can reinvest them into the company.
In other words, retained earnings refer to the undistributed profits of companies which are usually kept in the form of general reserve. The retained profits can be used for expansion and modernization plans by the companies.
The amount of retained earnings is determined by the quantum of profits, the dividend payout policy followed by the management, the legal provisions for dividend payment, and the rate of corporate taxes etc.
It is an internal source, which does not involve any cost of floatation and the uncertainties of external financing. It also strengthens the firm’s equity base, which enables to borrow at better terms and conditions.
The main drawbacks of this source are (a) it is fully dependent on the accuracy of profits; and (b) possibility of reckless use of funds by the management.
Advantages of Retained Earnings
- Ready Availability: Being an internal source, these earnings are readily available to the management and directors don’t have to ask outsiders for finance.
- Cheaper than External Equity: Retained earnings are cheaper than external equity because the floatation costs, brokerage costs, underwriting commission are other issue expenses are eliminated.
- No Ownership Dilution: Relying on retained earnings eliminates the fear of ownership dilution and loss of control by the existing shareholders.
- Positive Connotation: Retained earnings carry positive connotation as compared to equity issue as far as stock market is concerned.