Question

State the merits and demerits of public deposits and retained earnings as methods of business finance.

Answer 1

Public deposits: Organisations raise public deposits directly from the public to finance their short-term as well as medium-term financial requirements. The rate of return on such deposits is generally higher than the return paid on bank deposits. In case a person is interested in investing in a business (by depositing money), then he or she can submit a prescribed form along with the deposit. In return for this sum borrowed, the organisation issues a deposit receipt as a token of acknowledgment of the debt.

Merits of Public Deposits

(a) Raising money by accepting public deposits is a very simple process with few regulations involved.

(b) The cost of raising funds by accepting public deposits is generally lower than the cost involved in borrowing loans from commercial banks.

(c) The depositors do not have any voting or management rights. Thus, acceptance of public deposits does not result in any dilution of ownership of the business.

Demerits of Public Deposits

(a) The amount of money that can be raised from public deposits is limited as it depends on the availability of funds and the willingness of people to invest in the company concerned.

(b) Generally, it is difficult for new companies to raise capital through public deposits as people lack faith in them.

(c) When a firm has huge capital requirements, it may face difficulty in borrowing funds through the issue of public deposits.

Retained Earnings: Firms usually keep a certain part of the profits earned before distributing dividends to their shareholders. These undistributed profits are retained in the business for future use and are known as retained earnings.

Merits of Retained Earnings

(a) As these funds are raised internally, they do not involve any kind of explicit costs, such as floatation cost and interest.

(b) High amounts of retained earnings can lead to an increase in the price of equity shares.

(c) Since these are surplus profits retained in the business, they help in reducing the burden of unexpected losses.

Demerits of Retained Earnings

(a) Retained earnings are an uncertain source of finance as the business profits keep fluctuating from time to time.

(b) In case a firm reinvests a large portion of profits in the business, then very little funds are left for payments to the shareholders, and this creates dissatisfaction among them.

(c) Firms often fail to recognise the opportunity cost of the earnings retained in the business. As a result, these funds are often misused or sub-optimally used.