Like an individual, companies also set aside a part of their profits to meet future requirements of capital. The portion of the profits, which is not distributed among the shareholders but is retained and reinvested in business, is called retained earnings or ploughing back of profits.
As per Indian Companies Act 1956, companies are required to transfer a part of their profits in reserves like General Reserve, Debenture Redemption Reserve and Dividend Equalisation Reserve. These reserves can be used to meet long-term financial requirements like purchase of fixed assets, renovation and modernisations, etc. This method of financing long-term financial requirement is also called as Retention of Profit.
Following are the benefits of retention of profit:
Cheap Source of Capital: No expenses are incurred when capital is available from this source. There is no obligation on the part of the company either to pay interest or pay back the money. It can safely be used for expansion and modernisation of business.
Financial Stability: A company which has enough reserves can face ups and downs in business. Such companies can continue with their business even in depression, thus building up its goodwill.
Benefits to the Shareholders: Shareholders are assured of a stable dividend. When the company does not earn enough profit it can draw upon its reserves for payment of dividends. Not only that their holding size can improve with issue of bonus shares. Due to reserves, there is capital appreciation, i.e., the value of shares may go up in the share market.
Following are the limitations of retention of profit:
High Profit Required: This method of financing is possible only when the company earns huge profits and that too for many years.
Dissatisfaction Among Shareholders: Accumulation of profits often leads to low dividend payment by companies. Not only that, the companies may not utilise it for issue of bonus shares to avoid higher dividend payment. This may create dissatisfaction among the shareholders.
Mismanagement of Funds: Capital accumulated through retained earnings encourages management to be less careful with utilisation of funds which may lead to low profitability. It is not in the long run interest of the shareholders.