Retained earnings denote the profits not distributed among the shareholders. The proactive of retained earnings as a method of ‘ self financing’ is commonly used by the established companies. It is also known as ‘pouching’ back of profits’ or  ‘internal financing’. Under this method, the undistributed or retained profits of the company are used to finance the requirements of the company. A main features of this method is that it is an internal source of finance. A good company does not distribute its entire earnings in the form of dividend but rather retains a part of it every year. Such a policy helps the company to build up reserves which can be used for financing expansion programmers.

Merits of Retained Earnings. The advantages of ploughing back of profits are as follows:

(i)    It is a very economical method of financing because not return is to be paid on retained  earnings and no fixed obligations are created.

(ii)    It makes the company financially strong, increases its credit worthiness and enables it to float new securities in the market and borrow from the public and financial institutions without any difficulty.

(iii)    The reserves created by plough in back of profits can be used for redeeming debts and for replacing obsolete assets.

(iv)    Retained earnings can be a good sources of stabilizing the rate of dividend on equity shares.

(v)    Reinvestment of earnings increases capital formation which is necessary for the economic development of the country.

(vi)    Retained earnings enable the company to absorb the socks due to economic depression and uncertainly of the capital market.

Demerits of Retained Earnings. Excessive ploughing back of profits may be associated with certain drawbacks which are as follows:

(i)    The management of a company may misuse the retained earnings by investing them in unprofitable areas or by spending them unnecessarily.

(ii)    The management may utilize the retained earnings for issuing bonus shares to the equity shareholders which may lead to over-capitalization.

(iii)    The practice of retained earnings may be used to manipulate the price of share in the stock exchange with a view to purchase the shares by the directors. This will lead to deceiving of genuine investors and concentration of economic wealth in a few hands.

(iv)    The existing shareholders may be dissatisfied with the company because they get lower rate of dividend.

For more help in Retained Profits click the button below to submit your homework assignment