Retained earnings as the name suggest refers to those earnings of the company which is retained by the company and not distributed as dividends or bonus issues to its shareholders. In simple words, retained earnings are similar to an umbrella just like an umbrella protects us from unexpected rains, in the same way, retained earnings protect the company from unexpected loss or situations which happen during the course of the company doing a business. In order to have a better understanding about this term, one should look at some of the important features of retained earnings –
Retained Earnings Characteristics
Zero Cost of Financing
The first and foremost feature of retained earnings is that it is a zero cost of financing as far as the company is concerned because the company does not have to pay any interest which is the case when the company raises funds through borrowing or when the company issues debentures or for that matter even in case of equity financing there is a cost involved in the form of dividend payment to the shareholders of the company.
No Restrictions
Apart from zero cost, there are also no restrictions on the use of retained earnings which happens when the company raises funds through equity or debt route as debtholders, as well as equity shareholders, places many restrictions on the use and application of funds raised by the company. In simple words when you are driving a car with hand brakes on then it runs painfully slow, in the case of companies shareholders and debtholders are like that hand brakes which do not allow the owners to run the company freely.
No Repayment
In case of loans or debentures, the company has to repay the principal amount within a stipulated period of time, and if the company is not able to repay the principal amount then it may even go bankrupt as borrowers and debenture holders can file a lawsuit against the company for non-payment of the principal amount issued by the company from them. However, in the case of retained earnings, there is no such issue as these earnings are part of the capital of the company only, and no one can demand retained earnings from the company.
Acts as Shock Absorber
In case of an emergency or liquidity crunch, retained earnings can acts as a shock absorber for the company because in the absence of retained earnings company will have to take loan or debt at an exorbitant rate of interest which no company can afford to pay as it can lead to bankruptcy for the company. In simple words consider the example of an individual who has not much of savings and he or she meets with an accident than to save the life of an individual family will have to arrange funds either by taking loans at a higher rate of interest or by selling assets like house or gold which would not have happened if an individual had savings, the same thing applies to companies also as retained earnings acts like a buffer capital in case of emergencies which can happen to any company.
Trust Factor
A higher amount of retained earnings increases the trust factor in the minds of all parties related to the company whether its company shareholders who will assign higher valuation of the company in the stock market, employees of the company who will not leave the company, creditors of the company who will give funds to the company at a lower rate of interest and so on.
Shareholders Problem
Another characteristic of retained earnings is that too much of retained earnings can cause shareholders frustration because a company increasing retained earnings will imply that shareholders will get very little or no dividends which can be very frustrating for the shareholders of the company. Apart from no dividends, there is also a risk that owners of the company can misuse the retained earnings and divert the funds for their benefit rather than investing those funds for the betterment of the company.
As one can see from the above that retained earnings have some important characteristics and that is the reason why good companies having sound management always prefer to keep some profits as retained earnings so that they do not have to take any financial help or depend on others in case of any unforeseen circumstances.