Internal Source of Finance

The term ‘Internal Source of Finance / Capital’ itself suggests the very nature of finance / capital. This is the finance or capital which is generated internally by the business unlike finances such as loan which is externally arranged from banks or financial institutions. The internal source of finance is retained profits, the sale of assets and reduction / controlling of working capital.

Finance is a constant requirement for every growing business. There are several sources from where a business can acquire finance or capital which it requires. But, the finance manager cannot just choose any of them indifferently. Every type of finance has different pros and cons in terms of its cost, availability, eligibility, legal boundaries etc. Choosing a right source of finance is a challenge. We need to have an in-depth understanding of the characteristics of the source of finance. Let us focus first on the internal source of finance / capital.

Internal Sources of Finance are the sources of finance or capital for business firms which are generated by the business itself in its normal course of operations.

Internal Source of Finance – Retained Profits, Sale of Assets, Reduction of Working CapitalThe key characteristic is that there is no outside dependency for catering the need of capital. Internal sources of finance are:

Retained Profits / Retained Earnings

Retained profits/earnings are called the internal source of finance for a business for the simple reason that they are the end product of running a business. The phenomenon is also known as ‘Ploughing Back of Profits’. Retained profits can be defined as the profit left after paying a dividend to the shareholders or drawings by the capital owners.

Formula for retained profits can be stated as below:

Retained Profits / Retained Earnings = Net Profits – Dividend / Drawings

Characteristics of Retained Profits:

  1. Retained earnings are a long term source of finance for a company because there is no compulsory maturity like term loans and debentures.
  2. Retained profits are also not characterized by fixed burden of interest or installment payments like borrowed capital.

Pros and Cons of Retained Profits as an Internal source of finance / Capital:

The advantage of having retained profits/earnings is clearly seen in its characteristics. First, they are long-term finance and nobody can ask for their payments. Secondly, since there is no additional equity to be issued, there is no dilution of control and ownership in the business. Thirdly, there is no fixed obligation of interest or installment payments. Fourthly, retained earnings as an internal source of finance are cost effective considering the fact that there is no issue cost attached to it which ranges between 2 – 3 %. Lastly, investing retained earnings in the projects, with IRR better than ROI of the business, will directly have a positive impact the shareholder’s wealth and thereby the core objective of management will be served.

Sale of Assets

Another internal source of finance is the sale of assets. Whenever business sells off its assets and the cash generated is used internally for financing the capital needs, we call it an internal source of finance for sale of assets.

It can work as a short term or long term finance depending on what kind of assets are sold. Say, selling a car can cater short term and smaller finance needs and selling land, buildings or machinery can cater to long term and bigger finance needs.
A major drawback in this type of internal source of capital is that the benefits of useful assets which are sold can no more accrue to the business. A possible and perfect solution to that situation is ‘Sale and Lease Back’. It is a type of lease under which we can get the required cash and at the same time use the asset under concern in exchange for a lease rental. With this option, the business may end up paying more money in the long term but current finance problem can be solved.

Reduction or Controlling of Working Capital

It is interesting to know how a reduction in working capital can work as an internal source of finance. Working capital has broadly, the following components:

Current Assets, which include Stock / Inventory, Account Receivables – Debtors and Cash / Bank Balances

Current Liabilities: which include Account Payables – Creditors and Bank Overdraft.

Normally, a business requires two types of finance viz. long term finance for capital expenditure and working capital finance for day to day needs. Reduction in working capital can be achieved either by speeding up the cycle of account receivables and stock or by lengthening the cycle of account payables. In essence, both will reduce the working capital requirement and therefore the funds invested for working capital can be utilized for the other finance or capital requirements. This source has a little different analytics. This source is generated out of the efficient management of working capital and appropriate usage of working capital management techniques.

The internal source of finance is broadly covered under the above heads. Some other types of finance which are termed as an internal source of capital are the employee contribution to the finance requirements of the company and the personal savings of the owners.

Most of the times, a finance manager would try sourcing funds from internal sources because of the benefits as stated above. Businesses using an internal source of financing also shows a sign of good performance as the business is independently satisfying its requirements with the help of its own efficiencies and operational profits.

Last updated on : August 31st, 2017
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