Company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings.

Merits: 

• Retained earnings is a permanent source of funds available to an organisation. 
• It does not in involve any explicit cost in the form of interest, dividend or flotation cost. 
• As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
• It enhances the capacity of the business to absorb unexpected losses. 
• It may lead to increase ¡n the market price of the equity shares of a company.

Demerits: 

• Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends. 
• It is an uncertain source of funds as the profits of business are fluctuating. 
• The opportunity cost associated with these funds is not recognized by many firms. This may lead to sub-optimal use of the funds.