Question

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

Describe the disadvantages of Retained Earnings.

Answer 1

1. Low Dividends: Ploughing back of profits reduces the current rate of dividends. This may result in dissatisfaction among the shareholders as they do not get the expected rate of dividend.
2. Misuse and Speculation: Excessive reserves may make the management wasteful and extravagant. Management may misuse them by investing in unprofitable or undesirable channels. A company having large reserves may prompt its directors to indulge in speculation in the prices of its shares.
3. Unbalanced Growth: Retained profits may interfere in the balanced industrial growth of the country. The profits which might have been invested in other industries are reinvested in the same industry.
4. Overcapitalisation: Too much ploughing back of profits may prompt management to issue bonus shares. Frequent capitalisation of reserves may result in overcapitalisation.
5. Uncertain: Retained profits are an uncertain source of funds when the profits of the company fluctuate widely.