Internal accruals are used by corporate management for a number of reasons. The term depreciation refers to the capital expenditure allocation to various time periods for which the expenditure is expected to improve the financial condition of the firm. The depreciation charge is considered an internal source of funds and is a non-cash charge. The retained earnings make a portion of the equity earnings that are reinvested in the business.
Retained earnings may also be described as sacrifices made by the shareholders. Companies generally retain 30% to 80% of their after-tax profit for the financial growth of the firm. The reserves and surplus representing the accumulated retained earnings constitute an important source of long term financing.
The retained earnings of the firm are often capitalized by the business, if it has issued bonus shares.
Advantages and Disadvantages of Internal Accruals
The advantages of internal accruals:
- The retained earnings are easily available to the business, requiring no need to consult its lenders or shareholders.
- Control of the business is not weakened when it uses the retained earnings.
- The extra equity infusion is effectively represented by the retained earnings. Unlike external equity, retained earnings eliminate the losses and issue costs on account of under pricing.
- Stock markets view retained earnings in a more positive light than equities.
- There is a limit to how much a firm can earn from the retained earnings. As the companies are engaged in a stable dividend policy, the amount of the retained earnings by the firms is highly variable.
- There are many firms that do not fully support the opportunity cost of retained earnings. This makes the retained earnings easily available, and they may invest in the projects that are sub-marginal.
- The opportunity costs of retained earnings are quite high.