Explain the merits and demerits of retained earnings.
Explain the merits and demerits of retained earnings.
Merits: The merits of retained earnings as a source of finance are as follows
(i) Retained earnings are a permanent source of funds available to an organisation.
(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost.
(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
(iv) It enhances the capacity of the business to absorb unexpected losses.
(v) It may lead to increase in the market price of the equity shares of a company.
Demerits: The demerits of retained earnings are as follows :
(i) There is imbalanced growth as undistributed profits remain in the same industry.
(ii) Since the profits of business fluctuate from time to time, it is an uncertain source of funds.
(iii) Excessive retained earnings causes dissatisfaction amongst the shareholders as this reduces the amount of the dividend receivable by them.
(iv) Frequent capitalisation of reserves may result in over capitalisation.
(v) Many firms fail to recognise the opportunity cost associated with these funds. This results in the sub-optimal use of the funds.
Merits: The merits of retained earnings as a source of finance are as follows
(i) Retained earnings are a permanent source of funds available to an organisation.
(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost.
(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
(iv) It enhances the capacity of the business to absorb unexpected losses.
(v) It may lead to increase in the market price of the equity shares of a company.
Demerits: The demerits of retained earnings are as follows :
(i) There is imbalanced growth as undistributed profits remain in the same industry.
(ii) Since the profits of business fluctuate from time to time, it is an uncertain source of funds.
(iii) Excessive retained earnings causes dissatisfaction amongst the shareholders as this reduces the amount of the dividend receivable by them.
(iv) Frequent capitalisation of reserves may result in over capitalisation.
(v) Many firms fail to recognise the opportunity cost associated with these funds. This results in the sub-optimal use of the funds.
