Question

Companies which follow a liberal dividend policy may not benefit from Self-financing method by retaining its profits.

Justify this statement by discussing any three advantages and any two disadvantages of Retained Earnings.

Answer 1

i. Advantages of retained earnings:

1. Dependable Source: Being an internal source, retained earnings are a more dependable and permanent source of finance than external sources of funds. This is because all external sources depend upon market conditions, the preference of the creditors, etc.
2. No Explicit Cost: Using retained earnings does not involve any costs to be incurred, as no expenditure is to be made on issuing prospectus, advertising, floatation costs, etc.
3. No Fixed Liability: There is no fixed liability to pay dividends or interest on this source of funds, as retained earnings are internally generated funds of the company own money.
4. No Interference: When a company utilises its retained profits, it does not need to issue any new shares. As a result, there is no risk of dilution of control in the organisation.
5. No Security: Unlike debentures, no charge is created on the assets of the company. As a result, the company is free to use its assets for raising loans in the future.
6. Goodwill: Retained earnings add to the financial strength and credibility of the company. Large reserves enable businesses to respond with ease to any crisis or unforeseen contingency. Retained earnings may lead to an increase in the market price of the equity shares.

ii. Retained Earnings has the following limitations:

1. Dissatisfaction: In cases of excessive ploughing back of profits, i.e., where a major portion of the profits has been kept in the form of reserves, the shareholders might be disappointed by the lower amounts of dividends paid to them.
2. Uncertainty: Retained earnings are a highly uncertain method of raising funds since the profits of a business are always fluctuating.
3. Opportunity Cost: The opportunity cost associated with the usage of retained profits is often overlooked or sometimes not even recognised by a lot of firms, which leads to suboptimal usage of the funds.