Discuss the merits and demerits of retained earnings as a source of business finance.
Discuss the merits and demerits of retained earnings as a source of business finance.
The merits and demerits to which retained earnings are subjects to are as follows:
Merits-
(a) Ready availability: Being an internal source, these earnings are readily available to the business therefore considered as a permanent source of funds.
(b) Cheaper: Retained earnings are cheaper than external equity because the floatation cost, brokerage costs, underwriting commissions and so on expenses are eliminated.
(c) No ownership dilution: Relying on retained earnings eliminates the fear of ownership dilution and loss of control by the existing shareholder and offers a greater degree of operational freedom.
Demerits-
(a) Limited finance: The amount which can be raised by way of retained earnings will be limited to an extent only.
(b) Hight opportunity cost: The retained earnings are made out of undistributed profits of a company which are retained instead of distributed as a dividend to shareholders. This sacrifice of profits by shareholders increases the opportunity cost of retained earnings.
(c) Uncertain source: As the profits of a business are fluctuating, it is an uncertain source of funds. It is not suitable for newly established companies.
The merits and demerits to which retained earnings are subjects to are as follows:
Merits-
(a) Ready availability: Being an internal source, these earnings are readily available to the business therefore considered as a permanent source of funds.
(b) Cheaper: Retained earnings are cheaper than external equity because the floatation cost, brokerage costs, underwriting commissions and so on expenses are eliminated.
(c) No ownership dilution: Relying on retained earnings eliminates the fear of ownership dilution and loss of control by the existing shareholder and offers a greater degree of operational freedom.
Demerits-
(a) Limited finance: The amount which can be raised by way of retained earnings will be limited to an extent only.
(b) Hight opportunity cost: The retained earnings are made out of undistributed profits of a company which are retained instead of distributed as a dividend to shareholders. This sacrifice of profits by shareholders increases the opportunity cost of retained earnings.
(c) Uncertain source: As the profits of a business are fluctuating, it is an uncertain source of funds. It is not suitable for newly established companies.
