[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
(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.
Also Read: Dividend Decisions Important Questions for Upcoming Exams
Q. What is Dividend and Dividend Policy? What are various types of dividend and dividend policies? 2014SN, 2015, 2016, 2017
Q. What are the factors affecting dividend decision of a firm? 2014
Q. Explain the MM theory of dividend distribution. Mention its assumptions. What are the major criticisms to this theory of irrelevance? 2012, 2013, 2015, 2016, 2018, 2021
Q. Explain the Walter’s theory of dividend distribution. Mention its assumption. What are the shortcomings tothis theory? 2017, 2019, 2022
Q. What do you mean by ploughing backof profits? Mention the purpose of creating it. What are the factors thatinfluence the ploughing back of profit? 2012, 2013, 2014, 2019, 2021
Q. Write Short notes on:
Ø Stable Dividend policy 2012, 2017
Ø Optimal Payout Ratio 2013, 2017, 2022
Ø Dividend Payout Ratio 2014
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