Retained Earnings

Meaning: A company usually does not distribute all its profits to shareholders as dividends. A portion of the net earnings is kept back in the business for future use — this is called retained earnings. It is a form of internal financing (also called self-financing or the "ploughing back of profits"). How much profit is available to plough back depends on factors such as the firm's net profits, its dividend policy, and the age of the organisation.

Merits

• Permanent source: It is a permanent source of funds for the organisation.
• No explicit cost: It involves no explicit cost such as interest, dividend or floatation (issue) cost.
• Freedom and flexibility: Because the funds are generated internally, the firm enjoys greater operational freedom and flexibility.
• Cushion against losses: It strengthens the firm's capacity to absorb unexpected losses.
• May raise share price: It can lead to an increase in the market price of the company's equity shares.

Limitations

• Shareholder dissatisfaction: Excessive ploughing back means lower dividends, which can upset shareholders. …