Internal Financing

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CHAPTER VI

INTERNAL FINANCING

Every organization needs finance to carry on its operations and to achieve its objectives. These finances may be raised in the form of share capital, borrowings and ploughing back of profits. Procurement of capital is an important function of mgt, but the skill of management lies in the management of earnings.

v  MANAGEMENT OF EARNINGS

            The term mgt of earnings means how the earnings of a firm are utilized, i.e. how much is paid to the shareholders in the form of dividends and how much is retained and ploughed back in the business. The way the companies apportion their earnings between dividends and retention is known as management of earnings.

            Companies usually do not distribute the entire amount of earnings to the shareholders in the form of dividends but retain a part of it for the future expansion and growth to bear the future risks. A well-established policy regarding management of earnings must be formulated to secure the maximum benefit to the body corporate and its owners.

                            RESERVES AND SURPLUS

v  SURPLUS: MEANING AND IMPORTANCE

           

            There are different views regarding the meaning and concept of surplus. According to one school of thought, the balance remaining after deducting the liabilities and share capital from the total of assets is known as ‘surplus’. In the opinion of the other school, ‘surplus’ represents the ‘undistributed earnings’ of a company, i.e. the balance of profits remaining after payment of dividends to the shareholders. Still, there are others in whose opinion ‘surplus’ is a left over which represents and addition to assets that is carried over on the ‘equity side’. But, surplus is solely equity of stockholders and not an asset in any sense of the word. In simple words, ‘surplus’ may be described as the net income of the company remaining after payment of dividend and all other expenses. It is the difference between the book value of the assets and the sum of liabilities and capital.

            Surplus is considered to be sort of a blanket covering of many corporate purposes. It is not merely a source of dividend, but has various other functions as well. It is regarded as a welcome sign by the management. It reflects upon the sound earning capacity of a firm. It enables a company to follow a stable dividend policy. A company can pay stable dividends even in the years when there are no sufficient profits. Surplus acts as a cushion to absorb the shocks of economy and business such as depression for the company. A company with large surplus can withstand the shocks of trade cycles and the uncertainty of the market with comfort, preparedness and economy.

           

v  KINDS AND SOURCES OF SURPLUS

                        The various kinds of surplus and their sources are discussed as below;

1.      Earned Surplus: - In the mind of a layman, surplus always implies earned surplus. The use of the term surplus as accumulation of past earnings accounts for its common identification with earned surplus. The main sources of earned surplus are;

1. Past accumulated profits
2. Net profits from business operations at the close of each financial year.
3. Retained earnings including income from business operations as well as non – operational incomes, such as profit on sale of fixed assets.
4. Conversion of reserves which are no longer required; and
5. Non – operating income

2.     Capital Surplus: - Capital surplus is that part of the surplus, which is not related directly to the operating results of the business. It results from;

         a. an increase in assets without a corresponding increase in liability or capital; and

         b. a decrease in capital or liabilities without a corresponding decrease in assets.

   3. Surplus from unrealized appreciation of assets: - During periods of prosperity or boom, the value of fixed assets may increase or intangible values may be added by accounting entries. Such a surplus is not realized because the assets are not actually sold but the effect of an appreciated surplus is created when a company appreciates its assets.

4. Surplus from realized appreciation of assets: - The sale of assets at prices in excess of book values may result in realized surplus.

5. Surplus from mergers, consolidations and reorganizations: - In mergers and consolidations, stock may be exchanged for stock and surpluses taken over by the new companies. Since mergers and consolidations are generally accompanied by an upward valuation of assets, the resulting surplus may be larger than the total of that resulting in an increase in surplus. Even unsuccessful companies may be increasing their book surplus through a forced reduction in abilities.

6. Surplus from reduction of share capital: - In periods of adversity, companies may create a surplus by reducing the liability of their stated capital. This process of creating a surplus involves a number of legal formalities and a sanction of the creditors.

7. Surplus from secret reserves: - A secret reserve is one, which is not disclosed in the balance sheet. Such a reserve may be created by;

            a. An understatement of income

            b. An excessive depreciation

            c. Inflation of capital expenditure

            d. An undervaluation of assets, and

            e. An overstatement of liabilities

This method of creating a surplus is not encouraged because it does not represent a true and fair view of the company’s financial position and provides an opportunity to the management for manipulation and misuse of the company’s funds.

8. Paid - in surplus: - It arises from the issue of shares at premium.

v  USES OF SURPLUS

Surplus may be broadly classified as (i) earned surplus and (ii) capital surplus. The uses of surplus have been discussed below keeping in mind such classification.

1. Uses of Earned Surplus

            The company for the following can utilize the accumulated earned surplus:

1. Reducing the value of fixed and working capital
2. Writing off intangible assets, such as, goodwill, preliminary expenses etc.
3. Equalizing the rate of dividend.
4. Financing schemes of expansion and growth.
5. Absorbing the shocks of business cycles; and
6. Supplementing other reserves.

2. Uses of Capital Surplus

            Capital surplus may be used for the following purpose;

1. For expansion and growth 
2. For protecting investments against a decline in values
3. For providing funds for working capital
4. For absorbing depreciation

v  MANUFACTURING OF SURPLUS

a.      Omission of certain liabilities

b.      Providing inadequate depreciation; and

c.       Providing insufficient taxes

Over statements of assets by;

1. Over valuation of certain assets, such as inventories
2. Considering unrealized profits
3. Not making a provision for bad and doubtful debts
4. Not taking into account the loss or shrinkage in the value of an asset

v  HIDING OF SURPLUS

                     Sometimes the companies hide their surplus for the various reasons, such as;

i. to prevent the shareholders from demanding the distribution of surplus

ii. to induce investors to sell their shareholdings to the management at less than its true           value

iii. to preserve the management from the temptation of paying large dividend

iv. to save heavy taxation

v. to prevent competitors

vi. to delay payments to creditors by impressing upon them their inability to pay immediately.

The various methods that are generally employed to hide the surplus are as follows.

1. Undervaluation of assets by:

a.      Charging excessive depreciation

b.      Charging capital expenses as revenue

c.       Witting off assets by charging against surplus

2. Overstatement of liabilities by:

1. Showing a contingent liability as an actual liability
2. Use of fictitious liabilities and
3. Providing excessive provision for taxation etc

v  RESERVES

In general, the term ‘reserve’ refers to the amount set aside out of profits. The amount may be set aside to cover any liability, contingency, commitment or depreciation in the value of assets. Reserves mean, therefore, amounts, which belong to the owners over and above, the capital contributed by them. If amounts equal to reserves are invested in outside investments, the reserve is called ‘Reserve Funds’. Technically speaking, the amount set aside out of profits may be either (i) a ‘provision’ or (ii) a ‘reserve’.

            A ‘provision’ means amount set aside as a charge against profits to meet:

a. Depreciation, renewals or diminution in the value of assets; and

b. Any known liability the amount of which cannot be known as yet, e.g. provision for doubtful debts, provision for repairs etc.

            The term ‘reserves’ also include other surpluses, which are not designed to meet any known liability, contingency, commitment or diminution in the value of assets. Such a reserve is not a charge against profits, but an appropriation of profits. In the modern days, the term reserve is used only in connection with a restriction on, or appropriation of retained earnings. Such an appropriation is made on account of the following:

1. To prevent the distribution of surplus in the form of dividends.
2. To provide additional capital, i.e., ploughing back of profits;
3. To provide for rainy days;
4. To enable equalization of dividends; and
5. To supplement other reserves

v  CLASSIFICATIONS OF RESERVS

Reserves are usually classified into two main categories: general reserves and specific reserves. These may again be classified as revenue reserves and capital reserve.

1.      General Reserve: - A general reserve is that part of the profits which is set aside to meet any future unknown contingency or emergency. It is also known as ‘Contingency Reserve’. A general reserve may be credited: (i) to meet the increasing demands of the business (ii) to stabilize the economic conditions of the firm (iii) to meet unforeseen losses and (iv) to control the profits of the company.

2.      Specific Reserve: - It is a reserve which is created for some definite or specific purpose i.e. Dividend Equalization Reserve, Reserve for Repair, Reserve for Outstanding Expenses, reserve for Building etc

3.      Revenue Reserve: - These reserves consist of un contributed revenue gains consisting of profits made in the ordinary course of business. The funds of these reserves may be used to maintain a business or pay dividends. Revenue reserves are ‘Free reserves’ that are available for distribution as profits.

4.      Capital Reserves: - These reserves are not available for distribution among shareholders as dividends. They are created to strengthen the financial position of the company. Capital reserves are built out of capital profits and not out of business profits, such as;

1. Profit prior to incorporation
2. Premium on issue of shares or debentures
3. Profit on redemption of debentures
4. Profit on forfeited shares
5. Profit on sale of fixed assets; and
6. Profit on revaluation of fixed assets.

Some other important types of reserves are discussed as below:

5.      Valuation or Assets Reserves: - Valuation reserves are set up to off set the loss of value of some assets. Such as plant and machinery, accounts receivables, investments, marketable securities and patents and intangibles which have a limited life. Such reserves are created with the following objectives:

1. to restore the integrity of investments which they have suffered or loss in value
2. to recognize expenses which cannot be determined accurately
3. to reduce assets to their estimated realizable values
4. to provide for losses arising out of bad debts; and
5. to provide for losses arising out of obsolescence

6.      Proprietary Reserves: - Proprietary reserves are elements of ‘padded surplus’ and are also referred to as surplus or ‘net worth reserves’. They are a part of shareholders equity which may be set up for the following purposes:

1. To provide cushion against future risks
2. To off set subjectivity in determination of profits
3. To reduce free surplus available for distribution to shareholders as dividends
4. To provide for future expansion and growth
5. To provide for repayment of debt; and
6. To increase the real value of the firm.

There are many kinds of proprietary reserves, which include;

1. Reserve for dividend i.e. Dividend Equalization Fund
2. Reserve for contingencies
3. Reserve for working capital
4. Reserve for improvement; and
5. Reserve for insurance etc

7.      Liability Reserves: - These reserves may be provided for current as well as emergency liabilities. Current Liabilities are known and are sure to materialize but the extent of the liability or the amount due is not certain. Reserve for taxation is an important example of such reserves. Emergency liabilities, on the other hand, may be non – recurring which may be established through transfer from contingency reserves.

8.      Funded Reserves: - A reserve does not mean cash or fund. It is merely a surplus appropriation that is included in shareholders equity. A fund is an actual asset in the form of cash or other investments. When the amount of reserve is invested in securities, etc., it is called funded reserve or ‘reserve fund’. A funded reserve protects the working capital position of the company and ensures the availability of funds and when needed.

9.       Sinking Fund Reserves: - A sinking fund is a fund built up by regular contribution / appropriation out of profits and the amount of interest on such contributions and the interest itself. The purpose of sinking fund may be either payment of a liability on a certain day in future or accumulation of funds to replace wasting assets.

10.  Secret Reserves: - A secret reserve is a surplus which although exists in a business but is not disclosed in the balance sheet. The management, to be conservative, may write down the value of the assets below their fair value of the purpose of creating a secret or ‘hidden reserve’. Secret reserves may be created by the simple method of showing profits at a figure much lower than the actual. When secret reserves exist, the financial position of the business is much better than what appears from the balance sheet.

Methods of Creating Secret Reserves

            Secret reserves may be created by any of the following method

9. Writing off excessive depreciation

ii.                  Charging capital expenditure as revenue expenditure

iii.                An understatement of income

iv.                An undervaluation of closing stock

v.                  An undervaluation of assets

vi.                An overstatement of liabilities

vii.              Capitalizing revenue receipts, and

viii.      Showing contingent liabilities as actual liabilities

ix.    Sometimes secret reserves may arise themselves, e.g., increase in the value of assets

Advantages of Secret Reserves

i.                    It is a means for stabilizing dividends

ii.                  It ensures a better financial position

iii.                It helps to hide out profits from the existing and potential competitors

iv.                It acts as a cushion during the rainy days, and save business from collapse,

v.                  It increases the actual capital employed in the business and improves the profitability

Disadvantages of Secret Reserves

i.                    Balance sheet does not reveal the true and fair position of the business

ii.                  Investors cannot make their buying and selling decisions correctly

iii.                Management can conceal its inefficiency

iv.                It provides an opportunity to the management for manipulation and misuse of the company’s funds

v  MEANING AND CONCEPT OF PLOUGHING BACK OF PROFITS

The ‘Ploughing Back of Profits’ is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend, but a part of the profits is retained or reinvested in the company. This process of retaining profits year after year and their utilization in the business is also known as ploughing back of profits.

It is actually an economical step, which a company takes, in the sense, that instead of distributing the entire earnings by way of dividend, it keeps a certain percentage of it to be re introduced into the business for its development. Such a phenomena is also known as ‘Self – financing’, ‘Internal Financing, or ‘Inter- Financing’. A part of profits is ploughed back or re-employed in to the business and is regarded as in ideal source of financing expansion and modernization schemes as there is no immediate pressure to pay a return on this portion of the stockholders equity. Under this method, a part of total profits is transferred to various reserves such as General Reserve, Replacement Fund, Reserve Fund, and Reserve for Repairs and Renewals, etc. Sometimes ‘secret reserves’ are created without the knowledge of the shareholders. From all the practices of financial management, this system of ploughing back of profits is considered desirable as it helps in the financial and economic stabilization of the concern.

v  THE NECESSITY OF PLOUGHING BACK

The need for re-investment of retained earnings or ploughing back of profits arises for the following purposes.

1. For the replacement of old assets which have become obsolete.
2. For the expansion and growth of the business
3. For contributing towards the fixed as well as the working capital needs of the company
4. For improving the efficiency of the plant and equipment
5. For making the company self- dependent of finance from outside sources
6. For redemption of loans and debentures

v FACTORS INFLUENCING THE RE-INVESTMENT OF PROFITS OR PLOUGHING-BACK OF PROFITS

The tool of ploughing back of profits can be successfully employed only by those concerns, which have stable earnings. Further; there are a number of factors that influence the ploughing back of profits in a concern.

1.      Earning Capacity: - Ploughing – back of profits depends largely upon the earning capacity of the company. If a concern does not earn sufficiently, there is no possibility of ploughing-back of profits. Usually, greater is the earning capacity of a company; larger is the possibility of ploughing-back of profits.

2.      Desire and Type of Shareholders: - The policy of ploughing back of profits is also affected by the desire and type of its shareholders. If shareholders largely belong to the class of retained persons, widows and other economically weaker persons, they may desire maximum distribution of profits as dividend. On the other hand, a wealthy investor may not mind if the company retains a portion of profits for future development.

3.      Future Financial Requirement: - Future financial requirements of the company also affect the policy of ploughing back of profits. If a company has highly profitable investment opportunities for future development, it may plough back its profits more successfully.

4.      Dividend Policy: - The re-investment of profits depends to a great extent upon the dividend policy of the company. If a company desires to plough back profits it cannot follow a policy of a very high dividend pay out.

5.      Taxation Policy: - The taxation policy of the Govt. also affects the re-investment of profits. A high or low rate of business taxation affects the net earnings of the company and thereby its re-investment policy.

v  MERITS OF ‘PLOUGHING BACK OF PROFITS’

Ploughing back of profits provides a number of advantages to the company, shareholders and the society at large. These merits are discussed as follows:

(A)  Advantages to the Company

1.      A cushion to absorb the shocks of economy: - Ploughing back of profits acts as a cushion to absorb the shocks of the economy and business such as depression for the company. A company with large reserves can withstand the shocks of trade cycles and the uncertainty of the market with comfort, preparedness and economy.

2.      Economical method of financing: - It acts as a very economical method of financing because the company does not depend upon outsiders for raising funds required for expansion, rationalization or growth.

3.      Aids in smooth and undisturbed running of the business: - It adds to the strength and stability of the company and aids it in smooth and undisturbed running of the business.

4.      Helps in following stable dividend policy: - Ploughing back of profits enables a company to follow a stable dividend policy. Stability of dividend simply refers to the payment of dividend regularly and a company, which ploughs back its profits, can easily pay stable dividend even in the years when there are no sufficient profits.

5.      Flexible financial structure: It allows the financial structure to remain completely flexible. As the company need not raise loans for further requirements if it ploughs back its profits, this further adds to the credit worthiness of the company.

6.      Makes the Company Self-dependent or No dependence on ‘fair weather friends’: - Ploughing back of profits makes the company self-dependent and it has not to depend upon outsiders such as banks, financial institutions, public deposits and debentures. Outsiders are just like fair weather friends, which may not allow finance when the company is not doing well. But a company with large reserves will not have to depend upon them.

7.      Helps in making good the deficiencies of depreciation, etc: - Companies with retained earnings can make good the deficiencies in the provision of depreciation, bad and doubtful debts, etc. For example, suppose a company provides depreciation at the rate of 10%p.a. on an asset costing Rs. 1 lakh. After 10 years when the asset has become obsolete and a new asset has to be purchased, the amount of depreciation fund may not be sufficient to purchase the new asset because of increase in prices. Say, the cost of asset at that time is Rs.2 lakhs, the deficiency in the depreciation fund may be met out of the retained earnings.

8.      Enables to redeem long-term liabilities: - It enables the company to redeem certain long-term liabilities such as debentures and thus relieves the company from the burden of fixed interest commitments.

(B)   Advantages to the Shareholders

1.      Increase in the value of shares: - Ploughing back of profits enables a company to adopt a stable dividend policy. Payment of stable dividends earns a good name for the company and the value of its shares goes up in the market. Thus the value of shares in the hands of the investors increases and they can dispose off their holdings earning higher profits and also can utilize their holdings as better collateral securities for borrowing from banks and other financial institutions.

2.      Safety of investments: - Retained earnings provide to the investors an assurance of a minimum rate of dividend. it renders safety to their investment in the company as the company can withstand the shocks of  trade cycles and the uncertainty of the financial market with ease, preparedness and economy.

3.      Enhanced earning capacity: - With the re-investment of profits in the business, the earning capacity of a concern is enhanced and the shareholders who are the real owners of the company are benefited.

4.      No dilution of control: - Due to the ploughing back of profits the company need not issue new shares for the future requirements of capital. This enables the existing shareholders to retain their control. For example, a company is not following the policy of ploughing back. It needs further capital for expansion. It will have to issue new shares or raise loans. If the existing shareholders are not in a position to buy new shares in the company, these will be issued to some other people. Thus, control of the existing shareholders will be diluted.

5.      Evasion of super tax: - Ploughing back of profits provides an opportunity for evasion of super-tax in a company where the number of shareholders is small.

(C)  Advantages to the Society or Nation

1.     Increases the rate of capital formation: - The policy of retained earnings increases the rate of capital formation and thus, indirectly promotes the economic development of the nation as a whole.

2.     Stimulates industrialization: - It stimulates industrialization of the country by providing self-finances. The society as a whole is benefited by rapid industrialization.

3.     Increase productivity: - As ploughing back of profits acts as a very economical method of financing for modernization and rationalization, it increases the industrial productivity of the nation. Hence, the scarce resources can be exploited fully for the optimal benefit of the people at large.

4.     Decreases the rate of industrial failure: - Retained earnings add to the strength and stability of the business enterprise, which are indispensable for the smooth and undisturbed running of the business. Thus, it helps to decrease the rate of industrial failures in the company.

5.     Higher standard of living: - Ploughing back of profits as the most economic method of financing increases productivity, facilitates greater, better and cheaper production of goods and services. The costs of the goods are decreased and the consumers stand to gain in the form of better quality goods at reduced prices. With the stability and smooth running of the business the employees also gain by way of security of their jobs and increased remunerations. Hence, the society at large is benefited by an increased standard of living.

Limitations or Dangers of Ploughing-back of Profits

                  Although ploughing back of profits offers a number of advantages as discussed above, excessive dependence on it poses many dangers. Pigou is of the opinion “Excessive ploughing back entails social waste, because the money is not made available to those who can use it to the best advantage for the community but is retained by those who have earned it”. The limitations of self-financing are as follows;

1.      Over-capitalization: - Over capitalization means, more capital than actually required. Excessive ploughing back of profits may lead to over-capitalization and the earnings of the company may not be sufficient to have a normal rate of return on capital employed by it.

2.      Creation of monopolies: - Continuous re-investment of earnings may lead a company to grow in to monopoly with all its evils. The company may expand to such limits that it becomes uncontrollable.

3.      Depriving the freedom of investors: - The policy of ploughing back of profits limits the amount of dividend payable to shareholders and this may frustrate the shareholders as they are deprived of the freedom to invest their earnings in better securities.

4.      Misuse of retained earnings: - Management may not utilize the retained earnings to the advantage of shareholders at large as they have the tendency to misuse the retained earnings by investing them to unprofitable areas.

5.      Manipulation in the value of shares: - Certain managements (directors) having vested interest may speculate in the shares by manipulating dividends. By paying lower dividends in the name of ploughing back of profits, such managements achieve their goal to purchase shares at reduced prices. Thus, such managements may easily deceive genuine investors by manipulating the value of shares.

6.      Evasion of taxes: - Certain companies retain earnings with a review to evade super profits tax. Such evasion of taxes reduces the revenue of the Govt. and is detrimental to the interests of the nation as a whole.

7.      Dissatisfaction among the shareholders: - Excessive retention of profits creates dissatisfaction among shareholders.

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