Q.What are retained earnings? State the factors that determine the amount of retained earnings a company can build up.

Retained earnings is the only source of owned capital a company generates entirely on its own, without approaching a single outside investor.

Retained earnings, also called ploughing back of profit or self-financing, is the process by which a company keeps back a part of its own profit rather than distributing it entirely as dividend, and reinvests that retained amount in the business itself. A prudent company almost never distributes its whole profit; a portion is set aside, year after year, in the form of a reserve, and this accumulated reserve is what constitutes the company's retained earnings. Where the company chooses to, it can later capitalise these retained earnings by converting them into bonus share capital — issuing new shares free of cost to existing equity shareholders — turning an internally generated reserve into permanent share capital without ever approaching outside investors.

Retained earnings differ from share capital in one important respect: they cannot serve as an initial source of finance for a newly formed company, since a company with no trading history has no profit yet to retain. They become genuinely significant only once a company has operated profitably for some years, which is why this source is characteristic of established, going concerns rather than new ones. As an internal source, retained earnings is also generally regarded as the simplest and cheapest way to raise long-term capital, since it carries no interest cost, no dividend commitment, and none of the procedural expense of a fresh public issue. …

A common mistake is describing retained earnings as an 'external' source; it is squarely internal, since the funds come from within the company's own operations rather than from any outside contributor. Students also sometimes forget that retained ear …