PLOUGHING BACK OF PROFITS/RETAINED EARNINGS

'Ploughing back of profits' is an important source of internal or self financing by a company. It refers to the process of retaining a part of the company's net profits for the purpose of reinvesting in the business itself. In other words, the savings generated internally by a company in the form of 'retained earnings' are ploughed back into the company for diversification of its business. It is actually the amount held back by the entrepreneur after paying a reasonable dividend to the shareholders of the company and these undistributed profits are used by the company to meet its present and future financial requirements. This reduces their dependence on funds from external sources in order to finance their regular business needs. Such a source of finance may be used by the company for the following purposes:

For expansion and growth of the business For strengthening the financial position of the company For meeting various working capital requirements of the company For redemption of old debts For replacement of obsolete assets and modernisation.

The amount of retained earnings in a company depends upon the following factors:

The amount of net profits is an important determinant of internal savings. Higher the net profit earned by a company, the greater is its capacity to plough back profits. The dividend policy of a company determines the extent to which the profits can be retained for reinvestment in the business. If a company follows a liberal and regular dividend policy, it may end up retaining lesser profits. But if it follows a conservative dividend policy, it has a chance of building up greater internal savings. Another factor is the rate of corporate tax imposed on the company. If the rate is high,then it may have lesser amount of internal savings. The age of a company also influences this amount. New companies are generally unable to retain much profits due to their desire to satisfy the shareholders. While the old companies may distribute smaller portion of their profits to shareholders and thus retain a larger amount of internal savings. The future plans of the company regarding modernisation and expansion also affects the amount of retained earnings.

The main advantages of ploughing back of profits to (a) company (b) shareholders and (c) society are as under:(A) Advantages to the Company. (i) Shock absorber. In a period of depression, the part of profits reinvested in business act as shock absorber. The company can easily face the shocks of ups and downs of business cycles. (ii) Aids in smooth running of business. This self financing method (ploughing back of profits)

aids in the smooth running of the business. (iii) Increase in credit worthiness of the company. A company which reinvests a part of profits every year into the business is considered a stable company. As such it increases the credit worthiness of the company. (iv) Self dependent company. A company which retains a part of profits becomes self dependent to a great extent. It depends less on outside agencies for financial help. (v) Expansion and growth of business. The company with retained earnings can spend funds for expansion modernization, replacement of machinery etc. (vi) Redemption of long term debts. A company which re-employs a part of profits into business is generally able to pay back its long term loans. (B) Advantages to the share holders. (i) Increase in the value of shares. A company which earns profits and reinvests a part of it into business year is considered a stable company. It earns a good name. As such the value of its shares rises in the share market. (ii) Increase in earning capacity. The retained earnings in the business helps the company to grow. It increases the earning capacity of the concern. (iii) Retaining the control. A self financing company need not issue new shares for its future capital requirements. This enables the existing share-holders to retain the control of the company. (C) Advantages to the society. (i) Increase in the rate of capital formations. The retained earnings in a business lead to expansion and growth of business. The rate of capital formation increases in the country. (ii) Rapid industrialization. The ploughing back of profits into business stimulates industrialization in the country. The nation as a whole thus benefits from it. (iii) Increase in industrial capacity. The reinvestment of profits in the business meets a part of the fixed and working needs of the company. The modernization and rationalization increase industrial production. (iv) Better quality of goods at reduced prices. The retained earning in business increases productivity reduces costs provides more jobs to the workers leads to increase in their wages etc.

The industries are able to produce better quality of goods at cheaper cost. Dangers of ploughing back of profits. Ploughing back of profits into business has a number of disadvantages. The main dangers or limitations of refinancing are as under:(i) Overcapitalization. If there is excessive ploughing back of profits, it may lead to overcapitalization of the company. The company may not be able to pay a fail rate of dividend to its shareholders. (ii) Reduces dividend. The reinvestment of profits reduces the amount of dividend payable to the shareholders. (iii) Evasion of taxes. A company may retain earnings with the sole object of evasion of super profits tax. Such evasion of taxes reduces the revenue of the government. (iv) Frustration among shareholders. If there is too much ploughing back of profits into business it creates dissatisfaction and frustration among shareholders.