Retained earnings means that part of trading profits which is not distributed in the form of dividends but retained by directors for future expansion of the company. Retained earnings ultimately come back to the equity shares in the form of enhanced dividend or capital gains.
Retained earnings is an internal source of finance available to the company. In other words, it is a sacrifice made by equity shareholders also referred to as internal equity. Companies normally retain 30 per cent to 80 percent of profit after tax for financing growth.
Advantages of Retained Earnings :
Retained Earnings are viewed as a favorable internal source of finance because of
(i) Ready Availability. Being an internal source, these earnings are readily available to the management and directors don't have to ask outsiders for finance.
(ii) Cheaper than External Equity. Retained earnings are cheaper than external equity because the floatation costs, brokerage costs, underwriting commission are other issue expenses are eliminated.
(iii) No Ownership Dilution. Relying on retained earnings eliminates the fear of ownership dilution and loss of control by the existing shareholders.
(iv) Positive Connotation. Retained earnings carry positive connotation as compared to equity issue as far as stock market is concerned.
Disadvantages of Retained Earnings:
The unfavorable views of retained earnings are as follows :
(i) Limited Finance. The amount which can be raised by way of retained earnings will be limited to an extent only. Keeping in view a stable dividend policy, the directors can't exhaust the whole balance retained. As a result, the variability of profit after tax is substantially transmitted to retained earnings.
(ii) High Opportunity Cost. The retained earnings are nothing but sacrifice of profits made by equity shareholders. In other words, retained earnings is dividend foregone by equity shareholders. This sacrifice increases the opportunity cost of retained earnings.