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: -
1.
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.
2.
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.
3.
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.
4.
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.
5.
Investors’
Confidence: - Retained Earnings indicate a healthy practice on the practice of
the company. Therefore, investors develop confidence in such companies.
6.
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.
7.
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.
8.
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
1.
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.
2. '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.
3.
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.
