Retained Earnings (Ploughing Back of Profits)

A third important owned source of long-term finance, and one that costs a company nothing to raise from outsiders, is retained earnings — the practice this chapter of the Andhra Pradesh Intermediate Commerce syllabus calls ploughing back of profits or self-financing.

When a company earns a profit, it does not always distribute the whole of it as dividend; a part is usually kept back in the business, year after year, and shown in the balance sheet as reserves and surplus. This retained portion of profit, accumulated over time and reinvested in the business, is called retained earnings, and because it belongs to the equity shareholders (as undistributed profit), it is treated as an owned source of finance, exactly like equity share capital.

Retained earnings offer several advantages. They involve no cost of raising funds — no underwriting commission, no brokerage, no prospectus expenses — since the money is already inside the company. They create no fixed obligation to pay interest or a guaranteed dividend, and they do not dilute the ownership or control of existing shareholders, since no new shares are issued to outsiders. Retained earnings also cushion a company during difficult years, acting as a built-in reserve that can absorb temporary losses or fund an unexpected need without approaching the capital market at all, and they improve a company's ability to raise additional funds later by strengthening its overall financial position and creditworthiness. …