Page 442 - Business Principles and Management

Chapter 16 • Financing a Business

mate the amount of money to distribute to shareholders when a corporation is
dissolved.

RETAINED EARNINGS
Normally, a good policy for a firm is not to distribute all of its profits. It is
better to hold some of its profits in reserve for use in the business through
retained earnings. If the corporation distributes all of its profits as dividends
to stockholders, it may later need to borrow money to carry on its opera-
tions. As illustrated in Figure 16-3, corporations usually distribute some of
their profits as dividends and keep some in the business as retained earnings.
In addition, if the corporation earns no profit during a particular period, it
can use retained earnings to pay dividends for that period. If the corporation
pays out all of its profits to stockholders, it has no retained earnings to fall
back on during tough times.
A business that retains some of its earnings to reinvest in the business is
“plowing back” earnings. A business plows back earnings for some or all of
the following reasons:

1. Replacement of buildings and equipment as the result of depreciation
(wearing out)
2. Replacement of equipment as a result of obsolescence (being out-of-date)
3. Addition of new facilities for expanding the business
4. The availability of cash to serve as financial protection during periods of
low sales and profits, such as recessions and tough competitive times
Even when the business is not making a profit, it should have financial plans
to replace assets that decrease in value because of depreciation or obsolescence.
For instance, a car rental company starts operations with all new cars. If the own-
ers of the business do not develop an asset replacement fund through retained
earnings and instead distribute all profits as dividends, funds will not be available
to buy new cars when the present ones wear out.

FIGURE 16-3 A corporation should retain some profits and distribute
the rest as stockholder dividends.

CORPORATE
PROFITS

DIVIDENDS RETAINED EARNINGS
STOCKHOLDERS BUSINESS

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