- Retained earnings refer to the portion of a company’s profits that are kept by the business usually a company rather than distributed as dividends to shareholders.
- Retained earnings can be used as a source of finance for a company.
Features of retained earnings
- Retained earnings are generated internally by the company.
- Retained earnings are not a direct cost to the company, as they do not involve any interest payments or issuance costs.
- Retained earnings do not dilute the ownership of the existing shareholders.
Situations where retained earnings would be most appropriate as a source of finance:
- When a company wants to finance new projects or investments, but does not want to take on additional debt or issue new shares.
- When a company is experiencing a temporary downturn and wants to maintain financial stability without taking on additional debt or diluting ownership.
Benefits of retained earnings as a source of finance:
- Increased flexibility: Retained earnings provide a flexible source of finance since companies can use them as needed for various purposes without any restrictions or repayment obligations.
- Improved creditworthiness: Companies with strong retained earnings are generally viewed as more creditworthy by lenders and investors, which can make it easier to obtain external financing on favourable terms.
- Reduced dependence on external financing: By using retained earnings as a source of finance, companies can reduce their reliance on external financing, which may be more expensive or harder to obtain.
- Greater investment opportunities: Retained earnings can be used to finance new investment projects or initiatives that can generate additional revenue or profits for the company.
- Higher dividends: Companies can use retained earnings to pay higher dividends to shareholders, which can increase investor confidence and attract new investors.
- Enhanced research and development: Retained earnings can be used to fund research and development activities, which can lead to the creation of new products or services and improved competitiveness in the market.
- Reduced tax liability: Retained earnings are not subject to corporate income tax, which can help reduce the company’s overall tax liability and improve its financial position.
Drawbacks of retained earnings as a source of finance:
- Opportunity cost: By retaining earnings, the company foregoes the opportunity to distribute dividends to shareholders or invest in other potentially profitable projects.
- Inflation: Inflation can erode the value of retained earnings over time, reducing their purchasing power.
- Limited availability: The availability of retained earnings may be limited in smaller or newer companies that have not yet generated significant profits.
- Tax implications: Retained earnings are subject to corporate income tax, reducing the amount of funds available for reinvestment or distribution to shareholders.
- Shareholder dissatisfaction: If the company consistently retains earnings rather than distributing dividends, shareholders may become dissatisfied and seek other investment opportunities.
- Lack of diversification: Depending solely on retained earnings as a source of finance can limit a company’s ability to diversify its funding sources and increase its financial flexibility.
- Increased pressure: Retaining earnings may put pressure on management to invest the funds in profitable projects, which can lead to riskier investments or poorly performing projects.
- Conflict of interest: The interests of management may not always align with those of shareholders, and retaining earnings may allow management to pursue personal interests rather than maximizing shareholder value.
