Meaning

Retained earnings is the part of profits of the company that is retained out of profits of the company for future use thus reinvestment also called ploughing back of profits or retention of profit.

As per Indian Companies Act 1956, companies are required to transfer a part of their profits in reserves like General Reserve, Debenture Redemption Reserve and Dividend Equalization Reserve etc. that can be used to meet long-term financial requirements like purchase of fixed assets, renovation and modernization etc.

Merits

1. Economical source:

No expenses are incurred, there is no obligation on the part of the company either to pay interest or pay back the money.

2. Financial stability:

A company having enough reserves can face ups and downs in business and can continue even in depression, thus building up its goodwill.

3. Benefits to the shareholders:

Shareholders are assured of a stable dividend. In case of issue of bonus shares they can further increase their wealth.

4. Increase in share prices:

Due to reserves, there is capital appreciation, i.e., the value of shares may go up in the share market.

5. Operational freedom:

Company can use these reserves as it pleases, no outside restrictions are there.

Limitations

1. Uncertain source:

This method of financing is possible only when the company earns huge profits and that too for many years.But in case the company is not able to earn sufficient profits this source an not be used.

2. Dissatisfaction among shareholders:

Accumulation of profits leads to low dividend payment by companies. Not only that, the companies may also skip the issue of bonus shares, which can create dissatisfaction among the shareholders.

3. Misuse of funds:

Capital accumulated through retained earnings encourages management to be less careful with utilization of funds which may lead to low profitability. It is not in the long run interest of the shareholders.

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