After reading this article you will learn about the merits and demerits of self-financing.
Merits of Self-Financing:
The advantages of ploughing back of profits or self-financing for the convenience of study can be classified under three groups:
(i) Advantages to the corporation,
(ii) Advantages to the shareholders, and
(iii) Advantages to the country or nation.
Advantages to the Corporation:
The policy of retained profits possesses the following advantages to the corporation:
1. A Cushion to Absorb the Shocks of Business Vicissitudes:
It gives benefit to the company that it can easily overcome periods of depression. Prosperity is never lasting. History gives evidence to the fact that a period of boom is always followed sooner or later by a period of slump or depression.
During depression period, it may be difficult for companies to meet the normal day-to-day expenses, not to speak of financing the schemes of rationalization or reconstruction. It is only the retained profit that enables the company to withstand the seasonal reactions and business fluctuations. It acts as a cushion to absorb the shocks of business cycles.
2. Ease in Financing Schemes of Rationalization:
Ploughing back of profits is the best device for financing the scheme of expansion and development. When a company expands its business or when any scheme of modernization, mechanization or automation is to be implemented, the retained earnings can be profitably utilized.
3. No Dependence on ‘Fair-weather Friends’:
In the absence of such a scheme, naturally ‘beg, borrow or steal’ are the only alternatives for financing the additional requirements of expansion or development of company. But such secret reserves, created out of the regular earnings of the company, enable the company to face the realities boldly and that, too, by standing on one’s own feet. There is no dependence on certain sources like public deposits.
4. Helps in Stabilizing the Dividend Policy:
Company can stabilize its dividend policy. If, due to some special circumstances, company has earned more-than usual profits and it can declare dividend at the rate of 6 per cent while it was 5 per cent. According to this policy, the balance 1 per cent be ploughed back for the needy days. Now take that unfortunately slump sets in and next year due to low earnings, the company is not in a position to pay more than 4 per cent. Under such circumstances, the retained profits of last year are used for dividend equalization.
5. Deficiencies of Depreciation Can be Made Good:
According to present economic conditions, a company is creating 10 per cent depreciation on its plant and machinery and after 15 years there arises a need to replace the asset. It is likely that due to war period the market price of that asset might increase three or four times than the pre-war price.
Hence, the Depreciation Fund may be insufficient to replace the worn out asset. Under such circumstances, the ploughed back profits can be utilized to make good the deficiency. The operating efficiency is thus maintained easily by the existence of corporate savings.
6. Early Retirement of Bonds or Debentures:
The undistributed income can also be used for retiring the bonds or debentures, for building up the sinking funds and for redeeming the debts. Thus, a company can be relieved of the fixed burden of interest charges.
Advantages to Shareholders:
The shareholders of a company, also stand to gain by this policy.
The advantages from their viewpoint may be summed up:
1. Safety of Investment:
Every investor wishes that his investment should be the safest and the return on the investment should at least remain constant, if it does not increase.
The policy of ploughing back of profits provides to the investors an assurance that:
(a) the dividend rate will not diminish.
(b) the investment is quite safe and sound,
(c) the company can easily withstand seasonal reactions and business fluctuations.
2. Rise in the Market Value of Securities:
Due to regular dividend payment, at a more or less stable rate, the company earns a repute and the market value of its shares goes up. Hence, if any shareholder needs hard cash, he can conveniently dispose of his holdings at a high price and earn the difference.
3. Profit by Retaining the Shares:
Even if the shares are retained, the shareholders stand to gain by the enhanced earning capacity of the company.
4. Evasion of Super-tax:
Ploughing back of profits in those concerns, where the number of shareholders is not much, provides an opportunity for the evasion of super-tax. The amended Indian Income-Tax Law provides sufficient safeguard.
Advantages to the Country or Nation:
The nation as a whole is also a gainer due to the following points:
1. Aid in Capital Formation:
The policy of ploughing back of profits is an important means of capital formation that is necessary for the economic development of a country, particularly is underdeveloped country. If the capital formation is at a snail’s speed, rapid industrialization would not be possible. Hence, ploughing back of profits, which is an important form of capital formation, indirectly stimulates the rapid industrialization of a country.
2. Greater, Better and Cheaper Production is Facilitated:
Self-financing is an economical device of financing the scheme of modernization and automation. Greater mechanization and automation facilitates greater, better and cheaper production of goods and services. When more goods and services at a reduced price are made available to the society, naturally the living standard must increase. In this way, the policy of retained profits, in the long run, goes to increase the standard of living of the masses.
3. Smooth and Continuous Functions of the Enterprise:
Even nation is interested in the smooth and continuous functioning of the old and new enterprises. Corporate savings provide the financial stability and flexibility which are indispensable for the successful operation of business enterprises.
Without this artificial cushion in the form of retained profits, the rate of industrial morality is likely to go up. Hence, by avoiding failure and other financial embarrassment, undistributed profits are a vital factor in relieving society from possible chaos and confusion.
4. Quick Financing of Rationalization Scheme:
In the absence of retained profits, it is likely that the implementation of the scheme of expansion, betterment or development may be put off due to shortage of capital. The corporate savings can be utilized for this purpose.
Demerits of Self-Financing:
If the policy of ploughing back is ill-planned and irrational, it may lead to following disadvantages:
1. Creation of Monopolies:
The inter-investment of earnings may go to expand the concerns to a limit when it may become uncontrollable to manage the affairs. Thus ploughing back may encourage the formation of monopolies with all the inherent evils.
2. Manipulation in the Value of Shares:
When the retained profits inflate, the management might be tempted to manipulate the value of securities by ‘paying’ with the dividend rate. At times, by retaining the earned profits, they declare lower rates of dividend, and thus bring down the market price of shares, with the intention to purchase them at a lower price.
3. Evasion of Tax:
Sometimes, earnings are retained to minimize the corporate profits so that the tax liability may be reduced. Now, the income-tax law has been amended in such a way that evasion of tax may not be possible by companies.
4. Misuse of Savings:
Corporate savings may not be used in the greatest good of the greatest number. It is likely that the retained profits of one company may be misused by the management in spoon-feeding the weaker links.
5. Over-Capitalization:
The collected reserves may result in overcapitalization of a company because its management may be inclined to capitalize the reserves by issue of bonus shares.
6. Interfering with the Freedom of the Investors:
Policy of dividend distribution interferes with the freedom of the investor if he wants that the old industry should expand or he would finance the setting up of a new concern.
In conclusion thereof, in the words of Pigou, “Excessive ploughing back entails social waste, as 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.”