Write short note on Retained profits.
Meaning: - every company is expected to distribute its profits among share holders as dividend. However, in practice the entire profit is not distributed. A part of every year’s profit is kept aside for future emergencies and reserves are created out of such undistributed profits. Reserves may be created for specific purpose or they may be kept as General Reserves. Sometimes the reserves are invested outside the company or sometimes general reserves are reinvested in the business of the company by converting them into bonus shares.
Companies normally retain a certain percentage of profit after tax for self financing. The percentage of retained earnings varies from company to company and from period to period.
Importance of Ploughing back/Retained of profits: -
- No Dilution of Control: -Retained earnings do not dilute the control over the working of the firm. The control remains with the existing shareholders. However, rising of more equity capital from the market dilutes owner’s control.
- Improvement of overall performance: -The Retained earnings can be utilized for expansion and modernization, which in turn can improve the overall performance of the organisation.
- No Interest Burden: -There is no cost of financing the Retained earnings. However, there is interest burden if the funds are obtained through fixed deposits and debentures.
- Flexibility for Utilising Funds: - There is lot of flexibility for utilizing the funds. The management can utilize the funds either for working capital or fixed capital.
- Investors’ Confidence: - Retained Earnings indicate a healthy practice on the practice of the company. Therefore, investors develop confidence in such companies.
- Increase Net Worth: - Retained Earnings increase net worth of a company. Net worth means equity capital + Free Reserves. The higher the net worth, the greater is the credit worthiness of the company.
- Buy-back of shares: - The Retained Earnings (Free Reserves) can be used for buy back of shares. The buy back is allowed under Indian Companies Act, in order to reduce the chance of hostile take-over.
- Reputation: - Retained Earnings improves image of the company. It improves credit worthiness of a company. Due to retained earnings, a company can easily obtain additional funds for expansion and modernisation.
Determinants of retained earnings
- Total earning of company: -If there is ample profit, company can save and retain some part of profit. 'Larger the earnings, larger the saving', is the principle put forth by economist J.M. Keynes. It is also a subject of attitude of top management to determine the part of retained earnings.
- 'Taxation policy: -The taxation policy of government is also an important determinant of corporate savings. If the taxes are levied at high rates, company cannot save much of the profit to be retained by it.
- Dividend policy: -It is policy of Board of Directors in regards to distribution of profit. A conservative dividend policy is need for having good accumulation of profit. This policy affects shareholders as they get dividend at low rate.
Government control: -A government is regulatory body of economic system of the country. Its policies, rules and regulations compel companies to work in that direction. A company has to formulate its dividend policy in accordance with the rules and regulations framed by government.