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 utilization 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 profit 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 in ideal source of financing expansion and modernization 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, and 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 stabilization of the concern.
The Necessity of Ploughing Back of Profits
The need for re-investment of retained earnings or ploughing back of profits arises for the following purposes:
- For the replacement of old assets, which have become obsolete.
- For the expansion and growth of the business.
- For contributing towards the fixed as well as the working capital needs of the company.
- For improving the efficiency of the plant and equipment.
- For making the company self-dependent of finance from outside sources.
- For redemption of loans and debentures.
Advantages
- Convenience: Ploughing back of profits are the most economical and convenient source of finance. No advertisement or prospectus has to be issued. No expenses or legal formalities are involved.
- No Charge on Assets: No charge or mortgage is created on the company’s assets. The company is free to use its assets for raising loans in future.
- No Obligations: There is no fixed burden of dividend and no obligation of repayment. Retained profits are the company’s own money.
- No Interference: Retained profits involve no risk of control being diluted as there is no increase in the number of shareholders. Management remains independent as no restrictions are put on the management.
- Goodwill: Retained profits add to the financial strength, credibility and earning capacity of the business. The company’s borrowing capacity is increased. It can safely face business cycles and other crisis. Retained profits provide a cushion of security during adverse conditions.
- Dependable: As an internal source of finance; Ploughing back of profits are more dependable than external sources. The amount of funds is not dependent on investors preference and market conditions.
- Growth and Expansion: Retained profits are very useful for financing new projects and expansion of business. These are also necessary for innovations and development of new products which are essential in industries like pharmaceuticals.
Disadvantages
- Low Dividends: Ploughing back of profits reduces the current rate of dividends. This may result in dissatisfaction among the shareholders as they do not get the expected rate of dividend.
- Speculation: A company having large reserves may prompt its directors to indulge in speculation in the prices of its shares. The directors may change the dividend rate to create price changes in their favors. Such price fluctuations may result in loss for the shareholders. The directors may also misuse the funds for personal benefits.
- Unbalanced Growth: Retained profits may interfere in the balanced industrial growth of the country. The profits which might have been invested in other industries are reinvested in the same industry.
- Over-capitalization: Too much ploughing back of profit may prompt management to issue bonus shares. Frequent capitalization of reserves may result in over-capitalization.