INTERNAL FINANCING

BY: BETSY MARIA JOSEPHINE S2 MBA

Retained earnings: merits to shareholders, society & its limitations.

company,

A new company has only external sources of finance available with it. However an existing company can generate finance through internal sources also. The 2 most important sources of internal financing are: 1) Depreciation 2) Retained Earnings Depreciation refers to the decrease in the value of asset due to wear & tear, lapse of time, obsolescence, exhaustion & accident. Retained earnings, although not a method of raising finance but refers to accumulation of profits by a company to finance its developmental activities & repay loans. It is known as Ploughing back of profits or Internal financing or self financing. The Ploughing back of profits is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend, but a part of the profits are retained for reinvestment in the company. This process of retaining profits year after year & their utilization in the business is called ploughing back of profits.

According to latest provisions of the Companies Act, a certain % of net profits after tax have to be compulsorily transferred to reserves by the company before declaring dividends. There are various such reserves like general reserves, reserve fund etc.

ADVANTAGES There are a number of advantages to the company, shareholders & society. To company: 1) Economical mode: it acts as a very economical method of financing because the company does not depend upon outsiders for raising funds required for expansion & growth. 2) Involves zero floatation costs: this method in comparison to others does not involve any floatation costs. 3) Strengthens its financial position: Since the company need not resort to loans & other sources it is free from such financial liabilities & hence it can retain its credit worthiness. 4) Reduced risk of uncertainty in economy: Retained earnings act as a cushion to absorb the uncertain situations in the economy such as depression for the company. A co. with large reserves can withstand the shocks of trade cycles & reduces risk of uncertainties.

To shareholders: 1) Increases value of shares: Retained earnings help co. to follow a stable dividend policy, which earns a good name for the co. 2) Safety of investments: It provides investors an assurance of a minimum rate of dividend. It renders safety to their investment in the company as co. can withstand the shocks of trade cycles. 3) Enhanced earning capacity: With reinvestment of profits in the business earning capacity of co. is enhanced & shareholders are hence benefited. 4) No dilution of control: Since no new shares are issued for funds, hence the control does not get diluted. 5) Evasion of super tax: Retained earnings provide an opportunity for evasion of super tax in a company where the number of shareholders is small.

To society: 1) Increased rate of capital formation: With more & more finance available, more & more investments take place leading to capital formation in the nation itself. 2) Stimulates industrialization: With more investments through self-finance the enterprise expands & so does industrialization expand.

3) Decreased rate of industry failure: With more funds retained in the company, the companys ability to absorb economy shocks is increased. So its chances for failure is reduced, hence are the chances for the industrys failure. 4) Higher standard of living: With increased capital formation & reduced failure rates, the economys conditions will develop & so also the standard of living increases.

DISADVANTAGES 1) Over capitalization: As more funds are retained by the company there are chances of over capitalization of funds, as funds may be invested overtly where they are not needed. 2) Creation of monopolies: As a lot of profits are retained there are chances of the company to become a monopoly power. 3) Misuse of retained earnings: The management can use the retained earnings for manipulation of share prices & other wrong purposes. 4) Evasion of tax: Retained earnings are also used for evasion of super tax.

5) Dissatisfaction among shareholders: With more profits retained, the satisfaction of its shareholders may be negatively affected as their freedom for investment is reduced.