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:
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.
Have you seen the tutor2u YouTube channel? Subscribe now and never miss a revision video!