Net income of a company has two elements. After paying a dividend to the shareholder, a portion of income is retained in the hands of a corporation, this portion of the profit is called retained earnings.
Merits of Retained Earnings:
1. Costless Means –
Retained earnings are one of the least costly sources of finance since it does not involve any flotation cost.
2. Permanent Means of Capital –
This is a permanent means of capital.
3. No fixed Liability –
No liability is fixed in case of retained earnings.
4. Increase in Market Price of equity shares –
When profits increase, it results in the increase in the market price of equity shares.
5. No Security –
There is no security in retained earnings.
6. Helpful in unexpected loss –
If a corporation faces an unexpected loss, then retained earnings are very helpful in it.
Demerits of Retained Earnings:
1. Discontentment in shareholders –
If the company uses retained earnings as a source of finance, the shareholders are unable to obtain more dividends.
2. Indefinite Source of Capital –
It can never be a definite source of capital because it is not essential that a company may make a profit only.
3. Carelessness in Use –
This income is generated very easily, therefore directors of the company become careless.
4. More Capitalisation –
The transfering of retained capital can sometimes result in more capitalisation. The image of the company is negatively impacted due to this.
