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What are retained earnings? Explain. Mention its merits and demerits as well.

Retained Earnings

A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or selffinancing or ‘ploughing back of profits’. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.



The merits of retained earning as a source of finance are as follows:

(i) Retained earnings is a permanent source of funds available to an organisation;

(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost;

(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility;

(iv) It enhances the capacity of the business to absorb unexpected losses;

(v) It may lead to increase in the market price of the equity shares of a company.


Retained earning as a source of funds has the following limitations:

(i) Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends;

(ii) It is an uncertain source of funds as the profits of business are fluctuating;

(iii) The opportunity cost associated with these funds is not recognized by many firms. This may lead to Sub optimal use of the funds.


Explain trade credit and factoring mentioning their merits and demerits.

Trade Credit

Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers.



The important merits of trade credit are as follows:

(i) Trade credit is a convenient and continuous source of funds;

(ii) Trade credit may be readily available in case the credit worthiness of the customers is known to the seller;

(iii) Trade credit needs to promote the sales of an organisation;

(iv) If an organisation wants to increase its inventory level in order to meet expected rise in the sales volume in the near future, it may use trade credit to, finance the same;

(v) It does not create any charge on the assets of the firm while providing funds.



Trade credit as a source of funds has certain limitations, which are given as follows:

(i) Availability of easy and flexible trade credit facilities may induce a firm to indulge in overtrading, this may add to the risks of the firm;

(ii) Only limited amount of funds can be generated through trade credit;

(iii) It is generally a costly source of funds as compared to most other sources of raising money.


What is a commercial paper? What are its advantages and limitations.

Commercial Paper (CP)

Commercial Paper evolved as a source of short term finance in our country in the early years of 1990s. Commercial paper can be defined as an unsecured promissory note issued by an organisation to raise funds for a short period of time ranging from 90 days to 364 days. It is issued by one organisation to other business organizations viz., insurance companies, pension funds and banks. The money raised by CP is usually very sizeable. The debt being unsecured, the organisation having good credit rating is entitled to issue the CP. Its regulation falls under the purview of the Reserve Bank of India. The merits and limitations of a Commercial Paper are as follows:



(i) A commercial paper is very insecure and does not contain any restrictive conditions;

(ii) Due to its freely transferable nature, it has high liquidity;

(iii) It is liable to provide more funds compared to other sources. Generally, the cost of CP to the issuing firm is comparatively lower than the cost of commercial bank loans;

(iv) A commercial paper generates a continuous source of funds. This is due to the maturity that can be tailored to suit the needs of the issuing firm. In addition to this, the a commercial paper that matures can be repaid by selling new commercial paper;

(v) Companies can deposit their surplus funds in commercial paper that can generate good returns.



(i) Companies that are wealthy and highly rated can raise money through commercial papers. New and moderately rated companies may not be in a position to raise funds through this method;

(ii) The magnitude of money that can be raised through commercial paper is limited to the glut liquidity available with the suppliers of funds at that point of time;

(iii) Commercial paper is a remote method of financing because when an organization is incapable of redeeming its commercial paper, an extension of the maturity period is not provided.


What are the factors that affect the choice of the source of funds?

Factors Affecting the Choice of the Source of Funds

Financial requirements of a business are of various types - long term, short term, fixed and fluctuating. Hence, business firms route to many types of sources for raising funds. Short-term borrowings offer the advantage of reduced cost owing to reduction of idle capital, but long - term borrowings are considered as an inevitable requirement on many grounds. Correspondingly, equity capital has a vital role to play in raising funds in a corporate sector. As we are aware, no source of funds is devoid of limitations, it is sensible to use a combination of sources, rather than relying only on a single source. There are numerous factors listed below that affect the choice of this combination and make it a very complex decision for the business.


(i) Cost: Here we look at two types of cost viz., the cost of procurement of funds and cost of utilising the funds. Both these costs should be taken into consideration while deciding about the source of funds used by an organization.


(ii) Financial Strength and Stability of Operations: The financial strength of a business also serves as a key determinant. While making the choice of source of funds, business should be financially sound so that the company is able to repay the principal amount and interest on the borrowed amount. When the income/financial position of the organisation is not stable, fixed charged funds like preference shares and debentures should be carefully selected as these add to the financial burden of the organization.


(iii) Form of Organisation and Legal Status: The form of business organisation and status plays a major role in the choice of a source for raising funds. For instance, a partnership firm cannot raise money by issuing equity shares as these can be issued only by a joint stock company.


(iv) Purpose and Time Period: Business should plan based on the time period for which the funds are utilized. A short-term need for example can be dealt by borrowing funds at low rate of interest through trade credit, commercial paper, etc. For long term finance, sources such as issue of shares and debentures are more apposite. Correspondingly, the main purpose for which funds are required need to be analyzed so that the source is matched with the utilization of the same.


(v) Risk Profile: Business should analyze every source of finance in terms of the risk involved. For instance, there is minimal risk in equity as the share capital has to be repaid only at the time of disolvency of the company and dividends need not be paid if profits are not generated. A loan on the other hand, has a settlement schedule for both the principal and the interest. It is mandatory to pay the interest irrespective of the profit or loss incurred by the company.


(vi) Control: There are certain sources of fund that may affect the control and power of the owners in the management of the company. Issuance of equity shares may lead to dilution of the control. For instance, as equity share holders enjoy voting rights, there are possibilities for the financial institutions to take control of the assets or impose conditions as part of the loan agreement. Thus, it is advisable for a business firm to analyze the extent to which they are willing to share their control over business.


(vii) Effect on Credit Worthiness: The credit worthiness in the market is affected by the dependence of business on certain sources. For example, issuance of secured debentures might affect the interest of unsecured creditors of the company and develop chances for an adverse effect and their willingness to extend further loans as credit to the company.


(viii) Flexibility and Ease: One another aspect affecting the choice of a source of finance is the flexibility and ease in availing funds. Restrictive provisions, detailed investigation, analysis and documentation in case of borrowings from banks and financial institutions could be the reason for a business organisations to avoid it, if other options are readily available.


(ix) Tax Benefits: Various other sources may also be weighed with respect to the tax benefits. For example, as the dividend on preference shares is not tax deductible, interest paid on debentures and loan is tax deductible and may, for this reason opt for seeking tax advantage.

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