Retained profit is by some way the most important and significant source of finance for an established profitable business.
The principle is simple. When a business makes a net profit, the owners have a choice: either extract it from the business by way of dividend, or reinvest it by leaving profits in the business.
Where do retained profits sit? Some might be in the bank; some might be spent on additional plant & machinery; perhaps some are reinvested in more inventories or used to reduce overdrafts or loans.
The total value of retained profits in a company can be seen in the "equity" section of the balance sheet.
Retained profits have several major advantages:
- They are cheap (though not free) – effectively the "cost of capital" of retained profits is the opportunity cost for shareholders of leaving profits in the business (i.e. the return they could have obtained elsewhere)
- They are very flexible – management have complete control over how they are reinvested and what proportion is kept rather than paid as dividends
- They do not dilute the ownership of the company
Are there any downsides to using retained profits as a source of finance?
Directors of quoted companies occasionally get criticised for restricting the value of dividends and for hoarding too much cash in the business. If retained profits don't result in higher profits then there is an argument that shareholders could make better returns by having the cash for themselves.