Question

Importance of Ploughing back of profit/ retained Earings/profits. and its determinants?

Answer 1

Meaning: -

Every company is expected to distribute its profits among shareholders as a dividend. However, in practice, the entire profit is not distributed. A part of every year’s profit is kept aside for future emergencies and reserves are created out of such undistributed profits. Reserves may be created for a specific purpose or they may be kept as General Reserves. Sometimes the reserves are invested outside the company or sometimes general reserves are reinvested in the business of the company by converting them into bonus shares. 
Companies normally retain a certain percentage of profit after tax for self-financing. The percentage of retained earnings varies from company to company and from period to period.

Importance of Ploughing back/Retained of profits: -

1. No Dilution of Control: -Retained earnings do not dilute the control over the working of the firm. The control remains with the existing shareholders. However, the rising of more equity capital from the market dilutes the owner’s control.

2. Improvement of overall performance: -The Retained earnings can be utilized for expansion and modernization, which in turn can improve the overall performance of the organization.

3. No Interest Burden: -There is no cost of financing the Retained earnings. However, there is an interest burden if the funds are obtained through fixed deposits and debentures.

4. Flexibility for Utilising Funds: - There is a lot of flexibility for utilizing the funds. The management can utilize the funds either for working capital or fixed capital.

5. Investors’ Confidence: - Retained Earnings indicate a healthy practice on the practice of the company. Therefore, investors develop confidence in such companies.

7. Increase Net Worth: - Retained Earnings increase the net worth of a company. Net worth means equity capital + Free Reserves. The higher the net worth, the greater is the creditworthiness of the company.
8. Buy-back of shares: - The Retained Earnings (Free Reserves) can be used for buyback of shares. The buyback is allowed under the Indian Companies Act, in order to reduce the chance of hostile take-over.

8. Reputation: - Retained Earnings improve the image of the company. It improves the creditworthiness of a company. Due to retained earnings, a company can easily obtain additional funds for expansion and modernization.

Determinants of retained earnings

1. Total earning of company: -If there is ample profit, the company can save and retain some part of the profit. 'Larger the earnings, larger the saving', is the principle put forth by economist J.M. Keynes. It is also a subject of the attitude of top management to determine the part of retained earnings.
2. Taxation policy: -The taxation policy of the government is also an
   important determinant of corporate savings. If the taxes are levied at high rates, the company cannot save much of the profit to be retained by it.
3. Dividend policy: -It is the policy of the Board of Directors in regard to the distribution of profit. A conservative dividend policy is a need for having a good accumulation of profit. This policy affects shareholders as they get dividends at a low rate.
4. Government control: -A government is a regulatory body of the economic system of the country. Its policies, rules, and regulations compel companies to work in that direction. A company has to formulate its dividend policy in accordance with the rules and regulations framed by the government.