The profits made by a business may be used in different ways. The owners may distribute the profits among themselves; if it is a joint stock company, the entire profit or part of it may be distributed among shareholders as dividend, or it may be retained by the company for use in the business itself.
A company which has the habit of retaining the profits in the business itself can be self dependent. When the company needs funds, it need not approach anybody for a loan as its own funds are available.
If a company were to borrow loans, a large amount of money would have to be paid as interest adding to the company’s expenses. But by retaining profit, the companies can use its own money and there is no question of payment of interest. The company thus saves on this expenditure.
A company may not want to divulge information related to the business to outsiders. But if the business were to apply for a loan, the lender would demand statements and documents which would have to be submitted. A company retaining its profits need not reveal any business information to people outside the business.
When a company borrows funds, say from a bank, it will have to provide some kind of security. In case of large loans, it may have to mortgage its property even. But for a company with retained profit, mortgaging is unnecessary as it has its own funds to dip into.
There will be good times when companies make huge profits and in lean times, the same companies may suffer losses. Normally, dividends are paid when a company makes profits. But a company with retained profit can use those funds to pay dividends even in the years when there are no profits.
A company which has the habit of retaining its profit, may be able to issue bonus shares with the accumulated funds thereby contributing to shareholder wealth.
By retaining the profit with the business, the company is actually depriving the shareholders from the money actually due to them.
It may so happen that the retained profit is misused by the company management. They may not use the money judiciously or they may even misappropriate it.
Profit when retained by a business over a period of time may lead to over capitalization.
If retained profit is not utilized by the business for a long period of time, it would be a waste. Prompt deployment of those funds in business would help the business to grow.
One of the financial ratios which are studied by lenders and investment in analysts is the ratio of retained profit to stockholders’ equity. This is to find out whether the profit earned is being distributed instead of being used in business and whether the company is relying on debt to fund business activities. Lenders also want to find out if owners of closely held companies are distributing dividends amongst themselves to the detriment of the company.