Retained profit is the profit kept in the company rather than paid out to shareholders as a dividend. Retained profit is widely regarded as the most important long-term source of finance for a business.
Not all businesses make a profit. But when they do, the owners face a choice:
• Take the profit out of the business – either as personal income or via a payment to shareholders
• Effectively reinvest the profit by leaving it in the business
Of course the owners can decide to do a little of both – pay a limited dividend and leave the remaining part of the profit in the bank.
Retained profits are an important and attractive source of finance for most profitable businesses. Why?
- Retained profits are a very cheap form of finance. What is the cost? Really it is only the return that shareholders could earn if they had their dividend payment (this is known as an opportunity cost). In cash terms, retained profits are “free” to the business – there is no interest to be paid.
- Retained profits are also very flexible. They can be left in the business as cash in the bank. They can be invested in more fixed assets, extra stocks and so on.
- Retained profits are also under the control of the business. It is up to the business owners to decide what to do with them, not the bank manager.