Retained Earnings or Ploughing Back of Profits Meaning, Need, Factors, Advantages, Disadvantages, Payout Ratio

[Retained Earnings or Ploughing Back of Profits Meaning, Need of Retained Earnings, Determinants of Retained Earnings, Advantages, Disadvantages, Dividend Payout Ratio]

Retained Earnings or Ploughing Back of Profit Meaning

Retained earnings are internal sources of finance for any company. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities. Retained earnings are called under different names such as self-finance; inter finance, and plugging back of profits.  As prescribed by the central government, a part (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year.

Under the retained earnings sources of finance, a reasonable part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.

Need of Retained Earnings

Retained earnings or profits are ploughed back for the following purposes.

1)      Purchasing new assets required for betterment, development and expansion of the company.

2)      Replacing the old assets which have become obsolete.

3)      Meeting the working capital needs of the company.

4)      Repayment of the old debts of the company.

Determinants or Factors of Retained Earnings or Ploughing Back of Profits

(a)    Total Earnings of the Enterprise: The question of saving can arise only when there are sufficient profits. So larger the earnings larger the savings, it is a common principle of financial management.

(b)   Taxation Policy of the Government: The report submitted by Taxation Enquiry Commission has brought into light that taxation policy of the Government tells upon it the taxes are levied at high rates. Hence, it is also an important determinant of corporate savings.

(c)    Dividend Policy: It is policy adapted by the top management (board of directors) in regards to distribution of profits. A conservative dividend policy is essential for having good accumulation of corporate savings. But, dividend policy is highly influenced by the income expectation of shareholders and by general environment prevailing in the country.

(d)   Government Attitudes and Control: Govt. is not only a silent spectator but a regulatory body of economic system of the country. Its policies, control order and regulatory instructions-all compel the organizations to work in that very direction for example compulsory Deposit Scheme which had been in force.

(e)   Other Factors : Other factors affecting the retained earnings are:

(a)    Tradition of industry.

(b)   General economic and social environment prevailing in the country.

(c)    Managerial attitudes and philosophy, etc.

Advantages of Retained Earnings

Retained earnings consist of the following important advantages:

From company point of view

1. Useful for expansion and diversification: Retained earnings are most useful to expansion and diversification of the business activities.

2. Economical sources of finance: Retained earnings are one of the least costly sources of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different types of securities.

3. No fixed obligation: If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest.

4. Flexible sources: Retained earnings allow the financial structure to remain completely flexible. The company need not raise loans for further requirements, if it has retained earnings.

5. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.

From shareholders point of view

6. Increase the share value: When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance; hence the value of the share will increase.

7. Increase earning capacity and high dividend: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion. Low cost of capital increases profitability of the company which in turn results into higher EPS and high dividend payout.

8. Bonus shares to shareholders: A company with high retained earnings can give bonus shares to existing shareholders.

Disadvantages of Retained Earnings

Retained earnings also have certain disadvantages:

1. Misuses: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.

2. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.

3. Over capitalization: Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance.

4. Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.

5. Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.

Calculation of Cost of Retained Earnings

Generally, retained earnings are considered as cost free source of financing. It is because neither dividend nor interest is payable on retained profit. However, this statement is not true. A shareholder of the company that retains more profit expects more income in future than the shareholders of the company that pay more dividends and retains less profit. Therefore, there is an opportunity cost of retained earnings. In other words, retained earnings are not a cost free source of financing. The cost of retained earning must be at least equal to shareholders rate of return on re-investment of dividend paid by the company.

Determination of Cost of Retained Earning

In the absence of any information relating to addition of cost of re-investment and extra burden of personal tax, the cost of retained earnings is considered to be equal to the cost of equity. However, the cost of retained earnings differs from the cost of equity when there is flotation cost to be paid by the shareholders on re-investment and personal tax rate of shareholders exists.

i) Cost of retained earnings when there is no flotation cost and personal tax rate applicable for shareholders:

Cost of retained earnings (kr) = Cost of equity (ke) = (D1/NP) +g where,

D1= expected dividend per share

NP= current selling price or net proceed

ii) Cost of retained earnings when there is flotation cost and personal tax rate applicable for shareholders:

Cost of retained earnings (kr) = Cost of equity (ke) x 1-fp) (1-tp)

Where,

Fp = flotation cost on re-investment (in fraction) by shareholders

Tp = Shareholders' personal tax rate.

Payout Ratio

Dividend Payout Ratio and Optimal Dividend Payout Ratio

The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders. Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. The dividend payout formula is calculated by dividing total dividend by the net income of the company i.e.

Dividend Payout Ratio = Total Dividend/Net income

Optimal Dividend Payout Ratio: Dividend payout ratio maximizes the firm’s value. A payout ratio which maximizes the firm’s value is called optimal dividend payout ratio. A firm achieves this dividend payout-ratio at that point where it minimises the total cost of financing.  The minimization of sum of total cost of financing produces a unique dividend payout ratio for the firm.