Retained Earnings

Not every source of owned capital comes from outside the company. 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, instead of distributing all of it to shareholders as dividend, and reinvests that retained amount in the business itself. A prudent company rarely distributes its entire profit; it sets aside a portion, year after year, as a reserve, and this accumulated reserve, built up over time out of the company's own earnings, is what constitutes retained earnings.

Retained earnings differ from share capital in one crucial respect that a Secretarial Practice student should note carefully: they cannot serve as an initial source of capital for a brand-new company, since a company with no trading history has no profit yet to retain. Retained earnings become a genuinely important source of finance only once a company has been operating profitably for some time, which is why this source is typically associated with well-established companies rather than newly incorporated ones. Once accumulated, a company can capitalise its retained earnings by converting them into bonus share capital, issuing bonus shares free of cost to existing equity shareholders — this is, functionally, how a reserve built quietly out of past profit eventually turns into permanent share capital of the company, without the company having to approach the market for fresh funds at all. As a source of finance, retained earnings are internal (generated from within the company, not raised from outsiders) and are widely regarded as the simplest and cheapest method of raising long-term capital, since there is no interest to pay, no dividend commitment attached to it, and none of the procedural cost of a public share or debenture issue. …