'Ploughing back of profits' is an important source of internal or self financing by a company. It refers to the process of retaining
a part of the company's net profits for the purpose of reinvesting in
the business itself. In other words, the savings generated internally
by a company in the form of 'retained earnings' are ploughed back into
the company for diversification of its business. It is actually the amount
held back by the entrepreneur after paying a reasonable dividend to the
shareholders of the company and these undistributed profits are used by
the company to meet its present and future financial requirements. This
reduces their dependence on funds from external sources in order to finance
their regular business needs. Such a source of finance may be used by
the company for the following purposes:-
- For expansion and growth
of the business
- For strengthening the financial position of the
- For meeting various working capital requirements of the
- For redemption of old debts
- For replacement of obsolete
assets and modernisation.
The amount of retained earnings in a company depends upon
the following factors:-
- The amount of net profits is an important determinant of internal savings. Higher the net profit earned by a company, the greater is its capacity to plough back profits.
- The dividend policy of a company determines the extent
to which the profits can be retained for reinvestment in the business.
If a company follows a liberal and regular dividend policy, it may end
up retaining lesser profits. But if it follows a conservative dividend
policy, it has a chance of building up greater internal savings.
- Another factor is the rate of corporate tax imposed on
the company. If the rate is high,then it may have lesser amount of internal
- The age of a company also influences this amount. New
companies are generally unable to retain much profits due to their desire
to satisfy the shareholders. While the old companies may distribute
smaller portion of their profits to shareholders and thus retain a larger
amount of internal savings.
- The future plans of the company regarding modernisation
and expansion also affects the amount of retained earnings.
Benefits of ploughing back of profits are:-
- A company with such reserves can face unforeseen contingencies;
capital market crisis and other downturns in the economy with lesser
difficulty and ease.
- Such reserves help to stabilise the dividend policy
of the company. It thus helps in improving the company's relations
with its shareholders. It even helps in appreciating the value of
- It is the most convenient and economical method of
finance and involves no legal formalities or negotiations.
- It helps to keep the financial structure of the company
fully flexible and even increases the credit-worthiness of the company.
- Growth and modernisation plans of a company will not
suffer due to lack of finance, if the company has such
Thus, it is an important beneficial factor in the
performance and growth of the company both in short and long term. But
a policy of excessive ploughing back of profits may be disadvantageous
for the company:-
- The heavy reinvestment of such profits, year
after year, by a company may cause dissatisfaction among shareholders
as they may get lower dividends.
- It may tempt the management to raise bonus shares to
the equity shareholders leading to over capitalisation of reserves.
- The company may not always use the retained earnings
to promote the interests of the shareholders. Instead, it may be invested
in unprofitable avenues or misused by locking them up in those business
concerns which are against the interests of the shareholders.
- It may be used to manipulate the share prices of stock
exchange. The company may keep the dividend rate very low so as to
purchase the shares at lower prices and later by increasing dividends
rates, it may reap benefits from higher share prices.
In order to protect the interests of shareholders, the
Companies Act contains rules regarding the payment of dividends
by a company:-
- The rate of dividends are to be declared at the General
Meeting and the rate recommended by the Board must be approved by the
shareholders in this meeting. The three preliminary conditions for declaration
of dividends are:-
- There must be profits
- The Board must recommend
the distribution of profits as dividend;and
- The general body of
shareholders must approve the Board's recommendations.
- The main sources of payment of dividends may be:-
- Current profits after providing for depreciation or
or accumulated profits of previous years or
- Out of both of the
- Moneys provided by the Central or State Government for
payment of dividend in pursuance of a guarantee given by that Government.
- Before declaring dividends for any financial year,a certain
prescribed percentage of profits will be transferred to the reserves
of the company. The company may voluntarily transfer a higher percentage
of net profits to reserve.
- If authorised by the articles,a company can pay dividend
in proportion to amount paid up on each share.If there is no such provision
in the articles,dividend shall be in proportion to the nominal value
of the shares.
- Dividend is payable only in cash (or cheque) except where
fully paid bonus shares are issued as per the articles,or it is adjusted
towards outstanding calls on shareholding.The dividend warrant shall
be sent to the registered address of the shareholder entitled to the
payment of dividend.
- The dividend must be paid within 30 days of the declaration
- Where there is dispute about the right to receive dividend
- Where it has been lawfully adjusted by the company against any
outstanding due from the shareholder
- Where non-payment is due
to certain directions given by the shareholder
- Where dividend
could not be paid due to operation of any law or
- Where failure
to pay dividend or post the dividend warrant within 30 days of declaration
has been due to a fault on the part of the company.