Notes On Retained Earnings:

       Retained Earnings or self financing refers to the mechanism of financing of business form internal sources in the form of depreciation and other reserves. Business enterprises try to save a part of their earnings to meet the future financial requirements of expansion, modernization, and replacement etc. this process of creating savings in the form of reserves and surplus for its consolidation in business is termed as self financing or ploughing back of profits or retained earnings.

Necessity of Retained Earnings:

       The need of ploughing back of profits or retained earnings arise on the following circumstances:

  1. For replacement of old assets which has become obsolete
  2. For growth and expansion of the firm
  3. For contributing towards the fixed and working capital need of the firm
  4. For modernization of the plant and machineries
  5. For redemption of loans and debentures.
Benefits to the Shareholders:

1. Safety of Investments:

       Every investor expects his investments to be safe and returns are constant. The policy of retained earnings assures the shareholders that:

  1. The investment is quite safe and sound
  2. The dividend rate will not be reduced
  3. The company can easily meet the business circle and seasonal variations.

2. Increase in the Market value of Shares:

       A company that declares dividends at a steady rate earns goodwill and the market value of the shares goes up. The shareholders may take the advantage of the increased value by selling their shares in the open market.

3. Benefits of Retained Earnings:

       The shareholders, instead of selling their shares, may also benefit themselves by the increased earnings capacity of the business. The real earnings of the shares will be higher.

4. High Collateral Values:

       Incase of taking loans and advances, the increased value of the shares also enables the shareholders to borrow the amount against security of such shares on better terms.

Merits of Retained Earnings:

I companies point of view:

1. Acts as a shock Absorber:

       Rational earnings enable the company to face the business fluctuation and the period of depressions that is inevitable.

2. Support during Dull Period:

      It is retained earnings that support the business development activities in adversities as in prosperity; the business can raise funds from their resources and not in the dull period.

3. Best Suited Rational Schemes:

       Self financing is the best device n financing rationalization schemes. It may be profitably invested when a company expands its business or carries out developmental schemes.

4. Easy in Retirement of Binds and Debentures:

       Self financing can also be used to redeem the bonds and debentures of the company. Thus the company can be relieved of the fixed burden with assets.

II Nations Point Of View:

1. Capital Formations:

       Retained Earnings increases the rate of capital formation and thus indirectly promotes economic development of the nation.

2. Industrialization:

       The policy of self financing stimulates industrialization in the country and thus the whole nation gets benefited.

3. Utilisation of Natural Resources:

       It increases the industrial productivity and thus ensures optimum utilisation of the scarce natural resources

4. Decreases the Rate of industrial Failure:

       Retained Earnings increases the strength and stability of the industries and thus increases its strength and sustenance capacity. This considerably decreases the rate of industrial failure.

Demerits of Retained Earnings:

1. Over-Capitalisation:

       Over-capital means more capital than what is actually required. Excessive retained earnings may lead to over-capitalisation and the company may not be able to give normal on capital employed.

2. Creation of monopolies:

       Constant re-investment of earnings may lead the company to grow into monopolies with all its defects. The company may expand to such limit that it becomes uncontrollable.

3. Depriving the Freedom of Investors:

       The policy of retained earnings limits the amount of dividends payable to the investors. This may frustrate the investors as they are deprived of their freedom to invest in better securities.

4. Misuse of Retained Earnings:

       Excessive dependence on retained earnings increases the capital of the company more than what is actually required. Excessive capital means idle funds which earns no profit for the business.

5. Tax Evasion:

       Certain companies retain earnings to evade the super profit taxes. Such evasion of taxes reduces the relevance of the government and is detrimental to the interest of the nations as a whole.