Question

Explain any four disadvantages of Retained Earnings.

Answer 1

1. Return on Investment is Not Guaranteed: Retained profits appear to be an open source of cash for making investments and developing your organisation, yet they are not always a safe alternative for shareholders. Though it is a cost-effective financing option for sudden financial needs, it is not completely free. Lower dividends may result in a missed opportunity for shareholders to claim a larger share of profits. The ROI determines whether shareholders will continue to invest in a company or seek other opportunities.
2. Dissatisfaction: If a corporation employs retained earnings as a source of finance, shareholders cannot receive additional dividends. Shareholders prefer not to rely solely on retained earnings for financing.
3. Possible Tax Evasion: One risky reason why businesses should avoid retained earnings is because they may lead to tax avoidance. Some may attempt to reduce the tax burden by retaining profits. Shareholders who do not require dividends may vote against them to avoid income tax. If a company's stock value rises due to profit retention, shareholders may choose to sell at a higher price or stop receiving dividends. Companies that attempt to retain earnings and are caught will face penalties later.
4. Over capitalisation: Excessive usage of retained earnings can lead to overcapitalization and insufficient financing.