After reading this article you will learn about the Ploughing Back of Profits:- 1. Meaning of Ploughing Bank of Profits 2. Necessity of Ploughing Back 3. Factors Influencing Re-Investment 4. Merits 5. Limitations.
- Meaning of Ploughing Bank of Profits
- Necessity of Ploughing Back
- Factors Influencing the Re-Investment of Profits
- Merits of Ploughing Back of Profits
- Limitations of Ploughing-Back of Profits
1. Meaning of Ploughing Bank of Profits:
The ‘Ploughing Back of Profits’ is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend, but a part of the profits is retained or reinvested in the company. This process of retaining profits year after year and their utilisation in the business is also known as ploughing back of profits.
It is actually an economical step which a company takes, in the sense, that instead of distributing the entire earnings by way of dividend, it keeps a certain percentage of it to be re-introduced into the business for its development. Such a phenomenon is also known as ‘Self-Financing’; ‘Internal Financing’ or ‘Inter- Financing’.
A part of profits is ploughed back or re-employed into the business and is regarded as an ideal source of financing expansion and modernisation schemes as there is no immediate pressure to pay a return on this portion of stockholders’ equity. Under this method, a part of total profits is transferred to various reserves such as General Reserve, Replacement Fund, Reserve Fund, Reserve for Repairs and Renewals, etc.
Sometimes ‘secret reserves’ are also created without the knowledge of the shareholders. From all the practices of financial management, this system of ploughing back of profits is considered desirable as it helps in the financial and economic stablisation of the concern.
2. Necessity of Ploughing Back:
The need for reinvestment of retained earnings or ploughing back of profits arises for the following purposes:
a. For the replacement of old assets which have become obsolete.
b. For the expansion and growth of the business.
c. For contributing towards the fixed as well as the working capital needs of the company.
d. For improving the efficiency of the plant and equipment.
e. For making the company self-dependent of finance from outside sources.
f. For redemption of loans and debentures.
3. Factors Influencing the Re-Investment of Profits:
The tool of ploughing back of profits can be successfully employed only by those concerns which have stable earnings, further; there are a number of factors that influence the ploughing back of profits in a concern:
a. Earning Capacity:
Ploughing-back of profits depends largely upon the earning capacity of the company. If a concern does not earn sufficiently, there is no possibility of ploughing-back of profits. Usually, greater is the earning capacity of a company, larger is the possibility of ploughing-back of profits.
b. Desire and Type of Shareholders:
The policy of ploughing back of profits is also affected by the desire and type of its shareholders. If shareholders largely belong to the class of retired persons, widows and other economically weaker persons, they may desire maximum distribution of profits as dividend. On the other hand, a wealthy investor may not mind if the company retains a portion of profits for future development.
c. Future Financial Requirement:
Future financial requirements of the company also affect the policy of ploughing back of profits. If a company has highly profitable investment opportunities for future development, it may plough back its profits more successfully.
d. Dividend Policy:
The re-investment of profits depends to a great extent upon the dividend policy of the company. If a company desires to plough back profits it cannot follow a policy of a very high dividend payout.
e. Taxation Policy:
The taxation policy of the Government also affects the re-investment of profits. A high or low rate of business taxation affects the net earnings of the company and thereby its re-investment policy.
4. Merits of Ploughing Back of Profits:
Ploughing back of profits provides a number of advantages to the company, shareholders and the society at large.
These merits are discussed as follows:
(I) Advantages to the Company:
a. A cushion to Absorb the Shocks of Economy:
Ploughing back of profits acts as a cushion to absorb the shocks of economy and business such as depression for the company. A company with large reserves can the withstand the shocks of trade cycles and the uncertainty of the market with comfort, preparedness and economy.
b. Economical Method of Financing:
It acts as a very economical method of financing because the company does not depend upon outsiders for raising funds required for expansion, rationalisation or growth.
c. Aids in Smooth and Undisturbed Running of the Business:
It adds to the strength and stability of the company and aids it in smooth and undisturbed running of the business.
d. Helps in Following Stable Dividend Policy:
Ploughing back of profits enables a company to follow a stable dividend policy. Stability of dividend simply refers to the payment of dividend regularly and a company which ploughs back its profits can easily pay stable dividends even in the years when there are no sufficient profits.
e. Flexible Financial Structure:
It allows the financial structure to remain completely flexible. As the company need not raise loans for further requirements if it ploughs back its profits, this further adds to the creditworthiness of the company.
f. Makes the Company Self-dependent or No Dependence on ‘Fair Weather Friends’:
Ploughing back of profits makes the company self-dependent and it has not to depend upon outsiders such as banks, financial institutions, public deposits and debentures. Outsiders are just like fair weather friends which may not allow finance when the company is not doing well. But a company with large reserves will not have to depend upon them.
g. Helps in Making Good the Deficiencies of Depreciation, etc.:
Companies with retained earnings can make good the deficiencies in the provision of depreciation, bad and doubtful debts, etc. For example, suppose a company provides depreciation at the rate of 10% p.a. on an asset costing Rs. 1 lakh.
After 10 years when the asset has become obsolete and a new asset has to be purchased, the amount of depreciation fund may not be sufficient to purchase the new asset because of increase in prices. Say, the cost of asset at that time is Rs. 2 lakhs, the deficiency in the depreciation fund may be met out of the retained earnings.
h. Enables to Redeem Long-term Liabilities:
It enables the company to redeem certain long-term liabilities such as debentures and thus relieves the company from the burden of fixed interest commitments.
(II) Advantages to the Shareholders:
a. Increase in the Value of Shares:
Ploughing back of profits enables a company to adopt a stable dividend policy. Payment of stable dividends earns a good name for the company and the value of its shares goes up in the market.
Thus, the value of the shares in the hands of the investors increases and they can dispose off their holdings earning higher profits and also can utilise their holdings as better collateral securities for borrowing from banks and other financial institutions.
b. Safety of Investments:
Retained earnings provide to the investors an assurance of a minimum rate of dividend. It renders safety to their investment in the company as the company as the company can withstand the shocks of trade cycles and the uncertainty of the financial market with ease, preparedness and economy.
c. Enhanced Earning Capacity:
With the re-investment of profits in the business, the earning capacity of a concern is enhanced and the shareholders who are the real owners of the company are benefited.
d. No Dilution of Control:
Due to the ploughing back of profits the company need not issue new shares for the future requirements of capital. This enables the existing shareholders to retain their control. For example, a company is not following the policy of ploughing back.
It needs further capital for expansion. It will have to issue new shares or raise loans. If the existing shareholders are not in a position to buy new shares in the company these will be issued to some other people. Thus, control of the existing shareholders will be diluted.
e. Evasion of Super Tax:
Ploughing back of profits provides an opportunity for evasion of super-tax in a company where the number of shareholders is small.
(III) Advantage to the Society or Nation:
Ploughing back of profits also offers certain advantages to the society at large:
a. Increases the Rate of Capital Formation:
The policy of retained earnings increases the rate of capital formation and thus, indirectly promotes the economic development of the nation as a whole.
b. Stimulates Industrialization:
It stimulates industrialisation of the country by providing self-finances. The society as a whole is benefited by rapid industrialisation.
c. Increases Productivity:
As ploughing back of profits acts as a very economical method of financing for modernisation and rationalisation, it increases the industrial productivity of the nation. Hence, the scarce resources can be exploited fully for the optimal benefit of the people at large.
d. Decreases the Rate of Industrial Failure:
Retained earnings add to the strength and stability of the business enterprises which are indispensable for the smooth and undisturbed running of the business. Thus, it helps to decrease the rate of industrial failures in the country.
e. Higher Standard of Living:
Ploughing back of profits as the most economic method of financing increases productivity, facilitates greater, better and cheaper production of goods and services. The cost of the goods is decreased and the consumers stand to gain in the form of better quality goods at reduced prices.
With the stability and smooth running of the business the employees also gain by way of security of their jobs and increased remunerations. Hence, the society at large is benefited by an increased standard of living.
5. Limitations of Ploughing-Back of Profits:
Although ploughing back of profits offers a number of advantages as discussed above, excessive dependence on it poses many dangers. Pigou is of the opinion. “Excessive ploughing back entails social waste, because the money is not made available to those who can use it to the best advantage for the community but is retained by those who have earned it.” The dangers or limitations of self-financing are as follows:
Over-capitalisation means, more capital than actually required. Excessive ploughing back of profits may lead to over-capitalisation and the earnings of the company may not be sufficient to have a normal rate of return on capital employed by it.
b. Creation of Monopolies:
Continuous re-investment of earnings may lead a company to grow into monopoly with all its evils. The company may expand to such limits that it becomes uncontrollable.
c. Depriving the Freedom of the Investors:
The policy of ploughing back of profits limits the amount of dividend payable to shareholders and this may frustrate the shareholders as they are deprived of the freedom to invest their earnings in better securities.
d. Misuse of Retained Earnings:
Management may not utilise the retained earnings to the advantage of shareholders at large as they have the tendency to misuse the retained earnings by investing them to unprofitable areas.
e. Manipulation in the Value of Shares:
Certain managements (directors) having vested interest may speculate in the shares by manipulating dividends. By paying lower dividends in the name of ploughing back of profits, such managements achieve their goal to purchase shares at reduced prices. Thus, genuine investors may be easily deceived by such managements by manipulating the value of shares.
f. Evasion of Taxes:
Certain companies retain earnings with a view to evade super-profits tax. Such evasion of taxes reduces the revenue of the Government and is detrimental to the interests of the nation as a whole.
g. Dissatisfaction among the Shareholders:
Excessive retention of profits creates dissatisfaction among the shareholders.