question_answer

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

Answer:

Ans.     Public Deposits: Deposits accepted from public directly by the companies are called public deposits. These deposits generally carry a rate of interest higher than the deposits in commercial banks.

Merits of Public Deposits

1. The procedure of obtaining deposits is simple and does not contain restrictive conditions.

2. Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.

3. Public company usually does not create a charge on the assets of the company. As the depositors do not have voting rights, it does not dilute control in the company.

Demerits of Public Deposits

1. It is difficult for a newly established company to be able to get funds from public deposits.

2. It is dependent on public response and can't be relied on if financial needs are urgent.

3. It is difficult especially when size of deposits is large.

Retained Earnings: For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend.

Merits of Retained Earnings:

(a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to the payment of cash.

(b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.

(c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

(d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.

(e) Another factor that may be of importance is the financial and taxation position of the company's shareholders. For example, because of consideration of taxation, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.

Demerits of Retained Earnings:

(a) A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing.

(b) At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.

(c) Scope of retained earnings is limited by amount of profits. A loss incurring firm has no source called retained earnings.