Financial Management and Business Data Analytics · Sources of Finance

Retained Earnings and Internal Sources of Finance

Updated 10 October 2026 · Fact-checked

Retained earnings are the part of a company's profit after tax that is not paid as dividend but kept in the business. This is called ploughing back of profits. With depreciation funds and other internal sources, it finances growth without raising outside capital. To answer, define, list sources, then give merits and limitations.

Understand Retained Earnings and Internal Sources

A business can raise money from two places: outside it or inside it. Internal sources are funds generated by the business itself through its operations. External sources are funds brought in from outsiders, such as new shares, debentures or bank loans.

The main internal source is retained earnings. A company earns profit, pays tax, and then decides how much to pay as dividend. The balance is kept back in reserves and surplus. Using this balance to finance expansion or replace assets is called ploughing back of profits (also called self-financing or internal financing).

Other internal sources include depreciation funds and provisions. Depreciation is a non-cash expense. It is charged against profit, but no cash leaves the business. The cash stays in the business and can be used for other purposes until the asset needs replacing. Note that depreciation does not create new money. It only keeps cash that would otherwise be taken out as profit. Other internal sources are sale of surplus or idle assets, better working capital management (for example, faster collection of receivables and lower stock) and accumulated provisions such as for tax or other liabilities, until they are paid.

Retained profits belong to equity shareholders. So retaining profit is, in effect, reinvesting their money. Shareholders give up the dividend now and expect higher value or future earnings in return. This is why retained earnings have a cost, even though no one is paid for them directly. The cost is the return shareholders expect, which you study under Cost of Retained Earnings.

For ratio work, the payout and retention ratios here are measured on earnings available to equity shareholders (profit after tax less preference dividend), using equity dividend only.

For exams, you must compare internal and external sources and present clear merits and limitations of retained earnings.

Key rules to remember

Retained earnings for the year: Retained earnings = Profit after tax − Dividends (equity and preference); Add this amount to the opening balance of reserves and surplus to get the closing balance.
Retention ratio: Retention ratio = Retained earnings ÷ Earnings available to equity shareholders = (Earnings available to equity − Equity dividend) ÷ Earnings available to equity; Earnings available to equity = Profit after tax − Preference dividend. Retained earnings here are after both dividends, so the numerator equals earnings available to equity less equity dividend. If there is no preference dividend, this equals Retained earnings ÷ Profit after tax. Show as a fraction or percentage.
Dividend payout ratio: Payout ratio = Equity dividend ÷ Earnings available to equity; Retention ratio = 1 − Payout ratio; Use equity dividend only, not preference dividend. The two ratios then add up to 1 (or 100%).
Cash generated internally (simple view): Internal cash = Retained profit + Depreciation (and other non-cash charges); Use this only when the question treats profit as cash. Check for working capital changes.

How to solve Retained Earnings and Internal Sources questions

Use this method for both theory and numerical questions on retained earnings and internal sources.

1Read the question to see whether it asks for meaning, merits, limitations, comparison or a calculation.
2For theory, define the term first in one or two lines. Give the source of funds and who owns it.
3List the internal sources relevant to the question: retained earnings, depreciation funds, provisions, sale of idle assets, working capital release.
4For merits and limitations, write separate headed points with a one-line reason for each. Do not just list words.
5For numbers, find profit after tax, then subtract all dividends (preference first, then equity) to get retained earnings.
6Compute the retention ratio or closing reserves if asked. Use earnings available to equity as the base and equity dividend only for the payout ratio. Show the formula and the working.
7Add depreciation only if the question asks for total internal funds, and state that it is a non-cash charge.
8End with a short conclusion linking to cost, control or growth, as the question suggests.

Quickest way: Five-line answer frame for merits and limitations

When to use it: Use for 4 to 6 mark theory questions when time is short.

Line 1: Define retained earnings as profit kept back after tax and dividend.
Line 2: State the merits in four short points: no issue cost, no dilution of control, no fixed obligation, financial strength.
Line 3: State the limitations in four short points: shareholders may want dividends, opportunity cost, risk of over-capitalisation or misuse, depends on profits.
Line 4: For depreciation funds, say it is a non-cash charge that keeps cash in the business.
Line 5: Add one comparison with external sources, such as speed and cost.

Common mistakes in Retained Earnings and Internal Sources

Saying retained earnings are free of cost.
No interest or dividend is paid, so students think there is no cost.
Fix: Say there is no explicit cost but an opportunity cost, equal to the return shareholders expect on the funds.
Treating depreciation as a source that creates new funds.
It appears as an add-back in cash flow and fund flow statements.
Fix: Explain that depreciation is a non-cash expense. It retains cash already earned from operations and does not bring in fresh money.
Subtracting only equity dividend and forgetting preference dividend.
Students focus on equity shareholders.
Fix: Subtract preference dividend first when finding earnings available to equity. Retained earnings come after all dividends paid or proposed as per the question.
Using preference dividend in the payout ratio.
Students divide total dividends by earnings available to equity.
Fix: Use equity dividend only in the payout ratio, with earnings available to equity as the base. Then retention ratio = 1 − payout ratio.
Confusing retained earnings with cash.
Reserves appear on the balance sheet, so students assume cash is available.
Fix: State that retained profit is already invested in assets. Reserves show the source, not the cash balance.
Listing merits and limitations without explanation.
Students write keywords to save time.
Fix: Add one reason for each point, for example no dilution of control because no new shares are issued.
Mixing up internal and external sources in a classification answer.
Sale of assets and trade credit look similar to students.
Fix: Internal sources come from the firm's own operations or assets. Trade credit, bank loans and new capital come from outsiders.

Worked examples

Example 1

Sundaram Textiles Ltd has a profit after tax of ₹48,00,000. It pays a preference dividend of ₹6,00,000 and an equity dividend of ₹18,00,000. Opening reserves and surplus are ₹70,00,000. Find the retained earnings for the year, the closing reserves and surplus, and the retention ratio on earnings available to equity shareholders.

Show the solution

Total dividends = ₹6,00,000 + ₹18,00,000 = ₹24,00,000.
Retained earnings = ₹48,00,000 − ₹24,00,000 = ₹24,00,000.
Closing reserves and surplus = ₹70,00,000 + ₹24,00,000 = ₹94,00,000.
Earnings available to equity = ₹48,00,000 − ₹6,00,000 = ₹42,00,000.
Payout ratio on equity = ₹18,00,000 ÷ ₹42,00,000 = 3/7, about 42.86%.
Retention ratio = 1 − 3/7 = 4/7, about 57.14%. Check: ₹24,00,000 ÷ ₹42,00,000 = 4/7.

Answer: Retained earnings are ₹24,00,000. Closing reserves and surplus are ₹94,00,000. The retention ratio is about 57.14%.

Example 2

Explain ploughing back of profits. State two merits and two limitations of it as a source of finance for Kaveri Engineering Ltd.

Show the solution

Define: Ploughing back of profits means keeping part of the net profit in the business, instead of distributing it as dividend, and using it to finance expansion, modernisation or working capital.
Merit 1: No issue cost and no formalities. The company does not pay underwriting or brokerage, and funds are available quickly.
Merit 2: No dilution of control and no fixed charge. No new shares are issued, and there is no interest or repayment obligation.
Limitation 1: Shareholders may be dissatisfied. They may want regular dividends, and the market price may be affected.
Limitation 2: Available only if the company earns profits. The amount is limited and may be misused or lead to over-capitalisation if invested in poor projects.
Conclude: It is a cheap and safe source for a profitable company, but it cannot meet large funding needs alone.

Answer: Ploughing back is reinvesting profit in the business. Merits: no issue cost and no dilution of control or fixed obligation. Limitations: shareholders may be dissatisfied, and the source depends on profits and may be misused.

Exam tips

Expect short theory questions on merits and limitations. Give four points each, with a one-line reason.
In MCQs, watch for traps such as depreciation being called a cash inflow or retained earnings being called costless.
For numerical questions, always deduct preference dividend before finding equity earnings and show the retention ratio as a fraction or percentage.
When asked to compare internal and external sources, present it as points: cost, control, risk, availability and amount.
Link this topic to Cost of Retained Earnings. Examiners may ask why retained funds carry an opportunity cost.

Practice questions from Sources of Finance

Retained Earnings and Internal Sources in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Retained Earnings and Internal Sources: frequently asked questions

What is ploughing back of profits?

It means retaining a part of the profit after tax in the business instead of paying it all as dividend. The retained amount is used to finance growth, replace assets or meet working capital needs. It is also called self-financing.

Are retained earnings really a cost-free source of finance?

No. There is no explicit payment like interest, but shareholders could have earned a return elsewhere on the dividend they gave up. This opportunity cost is measured as the cost of retained earnings.

Is depreciation a source of funds?

It is treated as an internal source because it is a non-cash charge. Cash equal to depreciation stays in the business instead of leaving as profit. It does not create new funds. It only retains funds earned from operations.

What is the difference between internal and external sources of finance?

Internal sources come from within the business, such as retained profits and depreciation. External sources come from outsiders, such as shares, debentures and loans. Internal sources avoid issue costs and control dilution but are limited in amount.