When a company reinvests total profits or some of its part in the business, in place of dividing it among the owners, it is known as ploughing back of profits or incomes.
In other words, the profits left out after partial payment of profits to the shareholders by the company, or its owners by the Business institution, for purposes of building up funds and reinvestment in business is known as ploughing Back of profits.
The savings of the company are also a source for financing its development.
By ploughing back of profits the company does not require to increase the equity shares thus probably not changing the control.
By doing so, the owners save some portion of the profits for making, required capital available for the development of the institution and thus manage finance from the profits of the company itself.
Advantages of Ploughing Back of Profits
Following are the advantages of ploughing back of profits or income:
- If a company earns substantial profits and reinvest a substantial portion of this profit in the business, then it does not have to depend upon the external sources.
- The financial position of the company gets sound by this source, due to an increase in ownership capital and funds.
- By this source, its own sources of the company increase quite substantially. Hence, the apprehension of the winding up of the business during depression gets reduced.
- By this source, the company is able to maintain the stability of the rate of dividend. On accrual of high profits, investments may be made and in case of low profits, the dividend at stable rates may be declared, by taking money from reserve funds.
- By this source, the expansion and modernization of industry become easier. As a result, the efficiency of the institution goes on increasing.
- Since the company has sufficient funds with it, due to this source, it may take the decisions unhesitatingly and may always maintain its production methods, modern machinery, and equipment, etc. Hence, the efficiency of the institution gets increased.
- By ploughing back of the profits, the rate of the capital formation increases in the country. Due to it, the rate of economic growth also becomes faster.
- It increases the rate of capital formation in the country, due to which the pace of industrialization gets fast and standards of living of people also go high.
Disadvantages of Ploughing Back of Profits
Following are the disadvantages of ploughing back of profits:
- When some companies earn high profits and reinvest its substantial portion in the company, then the Monopoly of such companies increases in the market.
- The managers may unutilized the funds of the company. They may invest the money of the company in some other company of their control. By doing so, there will be no profit to the shareholders of this company.
- When only a small portion of the profit is distributed to the shareholders, it may cause dissatisfaction among the shareholders and they may create obstacles in the functional operation of the company.
- The directors may cause a reduction in the prices of the shares in the market by retaining a major portion of the profits and declaring the low dividend. Then, by themselves purchasing shares at low prices, and thereafter by declaring high dividends, they may raise the share prices. By doing so, they may earn high profits.
- The high volume of reinvestment of profits and bonus shares allotted to the shareholders in time may cause recapitalization.
- It blocks the flow of capital in the capital market, causing difficulties for the new companies in raising funds.
- By reinvestment of profits, the shareholders do not get full profits and they get dissatisfied.
- Ploughing back of profits or income blocks the freedom of the investors.
Thus, now you know the advantages and disadvantages of ploughing back of profits.