question_answer 20)

State the merits and demerits of public deposits and retained earnings as methods of business finance.

Answer:

Public Deposits The deposits that are raised by organizations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. The amount raised from public deposits is generally used by the company for meeting the requirement of working capital. It can take care of both medium and short term financial requirements. Merits of Public Deposits (i) The procedure of obtaining deposits is simple and does not contain restrictive conditions as in case of a loan agreement. (ii) Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions. (iii) Public deposits do not usually create any charge on the assets of the company and hence the assets can be used as security for raising loans from other sources. (iv) The control of the company is not diluted as the depositors do not have voting rights. Limitations of Public Deposits (i) New companies generally find it difficult to raise fund;; through public deposits due to lack of goodwill. (ii) It is an unreliable source of finance as the public may not respond when the company needs money. (iii) Collection of public deposits may prove difficult, particularly when the size of deposits required is large. Retained Earnings The portion of the net earnings which is not distributed amongst the shareholders as dividends and is retained in the business for use in the future is known as retained earnings. It is a source of internal financing and is also termed as accumulated earning. Merits of Retained Earnings (i) Retained earnings is a permanent source of funds available to an organization. (ii) It does not involve any explicit cost in the form of interest, or floatation cost. (iii) There is a greater degree of operational freedom and flexibility as the funds are generated internally. (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. Limitations of Retained Earnings (i) High retention ratio 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 keep fluctuating. (iii) If the opportunity cost associated with these funds is high it may lead to sub-optimal use of the funds.