Question

Discuss the advantages of retained profits as a source of finance.

Describe the advantages of Retained Earnings.

Answer 1

1. Convenience: Retained profits are the most economical and convenient source of finance. No advertisement or prospectus has to be issued. No floatation expenses or legal formalities are involved.
2. No Charge on Assets: No charge or mortgage is created on the company's assets. The company is free to use its assets for raising loans in future.
3. No Obligations: There is no fixed burden of dividend and no obligation of repayment. Retained profits are the company's own money. These involve no explicit cost in the form of interest or dividend.
4. No Interference: Retained profits involve no risk of control being diluted as there is no increase in the number of shareholders. Management remains independent, as no restrictions are put on the management. There is operational freedom and flexibility of operations.
5. Goodwill: Retained profits add to the financial strength, credibility, and earning capacity of the business. The company's borrowing capacity is increased, allowing it to safely face business cycles and other crises. Retained profits provide a cushion of security during adverse conditions and unforeseen contingencies. These may lead to an increase in the market price of the company's equity shares.
6. Dependable: As an internal source of finance, retained profits are more dependable than external sources. The amount of funds is not dependent on investors' preferences and market conditions. Retained earnings are permanent funds.
7. Growth and Expansion: Retained profits are very useful for financing new projects and expansion of business. These are also necessary for innovations and development of new products which are essential in industries like pharmaceuticals.