Association of Chartered Certified Accountants (ACCA) Certification Practice Test

What type of financing includes money retained from profits?

1. Debt financing

2. Equity financing

3. Retained earnings

4. Government funding

The correct answer is: Retained earnings

Retained earnings represent profits that a company has generated over time but has not distributed to shareholders as dividends. This internal source of financing is crucial for businesses as it allows them to reinvest in operations, pay down debt, or save for future expenditures. Companies can use retained earnings to fund projects, purchase new equipment, or enhance working capital without incurring additional debts or issuing new equity. Using retained earnings is often a cost-effective way for companies to finance growth, as it does not involve any interest payments or obligations that come with debt financing. Additionally, relying on retained earnings helps maintain ownership control since no new shares are issued, which would dilute existing shareholders' equity. In contrast, debt financing involves borrowing from external sources, creating liabilities that must be repaid with interest. Equity financing entails raising capital by issuing shares, potentially diluting ownership among existing shareholders. Government funding usually refers to subsidies or grants from the government, which are not generated from the company’s own profits. The definition of retained earnings is fundamental in understanding a company's financial strategy, specifically how retained profits can facilitate growth without the need for external funding sources.