9.3 Retained earnings

Question 1

What are retained earnings?

Answer 1

Funds or equity finance in the form of undistributed profits attributable to ordinary shareholders.

Question 2

What are the advantages of using retained earnings for finance?

Answer 2

• these are the cheapest source of capital as there is no issue cost (as opposed to issuing shares)
• cash is immediately available
• there is no obligation to pay interest or pay back earnings
• management have flexibility in deciding how money can be used
• retained earnings are part of reserves, thus building goodwill.
• Shareholders may benefit from retained earnings through dividends

Question 3

What are the disadvantages of using retained earnings for finance?

Answer 3

• internally generated funds may be insufficient for financing activities
• investment timing might not match fund availability, causing a business to miss opportunities
• excessive ploughing back of profits could cause overcapitalisation.
• excessive savings might be better used for shareholder benefit
• excessive saving could mean the company might be starved of cash for daily operations