Question

What has retained earnings? Explain any two of its merits and two of its demerits.

Answer 1

Like an individual, companies too, set aside a part of their profit to meet future requirements. The portion of profits not distributed among the shareholders but retained and used in the business is called retained earnings. It is also referred to as ploughing back of profit. This is one of the important sources of internal financing used for fixed as well as working capital. Retained earnings increase the value of shareholders in the case of a growing firm.

Merits:
Cheaper Source of Financing: The use of retained earnings does not involve any acquisition cost. The company has no obligation to pay anything in respect of retained earnings.

Financial Stability: Retained earnings strengthen the financial position of a business and thereby give financial stability to the business.

Demerits:
Improper Utilization of Funds: If the purpose of utilization of retained earnings is not clearly stated, it may lead to careless spending of funds.

Over-capitalization: Conservative dividend policy leads to a huge accumulation of retained, earnings leading to over-capitalization.