Ploughing back profits and loan financing

Understanding Ploughing Back of Profits and Loan Financing

This document explores two important concepts in corporate finance: the ploughing back of profits and the merits and demerits of loan financing. These are fundamental strategies that impact how businesses grow and manage their financial resources.

Ploughing Back of Profits

Definition:

Ploughing back of profits, also known as retained earnings, self-financing, internal financing, or inter-financing, refers to the practice of a company reinvesting a portion of its profits back into the business instead of distributing all of it to shareholders as dividends. It's a method of financial management where a company retains a part of its earnings for future growth and expansion.

How it Works:

Instead of paying out all profits as dividends, the company sets aside a certain percentage of its net earnings to be used for various business purposes. This retained amount can be used for various purposes like funding new projects, research and development, acquisitions, or other capital expenditures.

Factors Affecting Ploughing Back of Profits:

Several factors influence a company’s decision to plough back profits:

Earning Capacity: The most important factor is the company's ability to generate profits. A company with high earning capacity has more room to retain earnings for reinvestment. Conversely, companies struggling to make profits will not have this option.

Desire and Type of Shareholders: The preferences of shareholders play a crucial role. Shareholders who rely on dividend income, such as retirees or those with weaker economic standing, might prefer higher dividend payouts, while wealthier investors might be more tolerant of the company retaining earnings for future growth.

Future Financial Requirements: If a company has attractive investment opportunities or expects future growth that needs capital, it may choose to plough back profits more aggressively.

Dividend Policy: The company's dividend policy has a direct impact on its ploughing back capacity. If a company is keen to reinvest profits, it will necessarily have to follow a policy of lower dividend payouts.

Taxation Policy: Government taxation policies affect the company’s net earnings and therefore its ability to reinvest profits. Higher business taxes will mean lesser earnings to be reinvested.

In Essence:

Ploughing back of profits is an economical way for a company to grow. Instead of relying solely on external financing (such as loans), it leverages its own earnings for development and expansion. It is a strategic way for businesses to reinvest their earnings for future prosperity.

Merits and Demerits of Loan Financing

Loan financing is a common method for businesses and individuals to acquire capital. It involves borrowing money from a financial institution (such as a bank) with a commitment to repay it over time, with interest.

Merits of Loan Financing:

Purchase Without Liquidity: Loans allow individuals and businesses to purchase goods, assets, or services even when they do not have sufficient funds on hand. It can facilitate major purchases like homes, cars, machinery, and other big ticket items.

Driver of Growth: Loans are a key component for growth, particularly for public and private sector companies that have big expansion plans. Businesses can use loan funds to invest in expansion and increase their productive capacity, without waiting for years to accumulate savings.

Provides Capital for Daily Operations: Banks provide special loans designed to fund day-to-day operational capital needs, helping companies with their cash flows and facilitating debtor-creditor agreements.

Better Interest Rates: Organized bank lending has replaced unorganized moneylenders, offering more reasonable interest rates and transparent loan terms. Bank loans are usually cheaper than loans from non-banking financial companies (NBFCs).

Flexibility: Loan terms are often flexible, allowing borrowers to choose the loan duration, EMI (Equated Monthly Installment) amounts, and sometimes negotiate interest rates.

Accounting & Tax Advantages: Interest payments on loans are tax-deductible, providing tax savings for borrowers. Loans also help with budgeting, especially fixed-rate loans which allow for predictable monthly expenses.

Ownership Remains with Borrower: Unlike equity financing, loans do not dilute ownership. This is beneficial to companies that want to raise capital without giving up a portion of the company to outside investors.

Cash Discount Opportunities: Loans can help businesses leverage cash discount opportunities, allowing them to save on purchases by making immediate cash payments. The cash discount benefit needs to be compared with the interest payment involved in the loan to make sure it's beneficial for the borrower.

Demerits of Bank Loan:

Additional Burden on Cost of Goods: Loans increase the overall cost of a purchase due to interest payments. The borrower ends up paying more than the original price of the item being bought on loan.

Security Needs and Creditworthiness: Obtaining a bank loan can be challenging without a good credit score or valuable collateral. Banks are hesitant to lend to borrowers with a poor credit history or those with inadequate assets to offer as security.

Partial Funding Requirement: Many term loans require a partial payment from the borrower's own funds. If the borrower lacks this upfront money, the bank might reject the loan application.

Strict Repayment Schedule: Loan agreements typically have strict repayment schedules that must be followed. Failure to do so can negatively impact the borrower's credit score and future borrowing ability.

Prepayment Penalties and Charges: Many banks charge borrowers for early loan repayments. These prepayment penalties can make early payoff of loans a financially disadvantageous decision.

In Essence:

Loan financing is a double-edged sword. It provides access to funds that can drive growth and enable purchases but can also lead to higher overall costs and potential financial strain due to interest payments and repayment obligations. It is crucial to weigh these factors carefully before opting for loan financing.