Updated July 12, 2023
Introduction to Internal Sources of Finance
Finance is the blood of any business. An entity’s operations start with the capital, i.e., the first source of finance, and end with liquidation proceeds, i.e., the last source. Finance can arrange through internal as well as external sources.
However, a finance manager cannot just go with any option abruptly. Each option of finance has its good and bad sides, considering the cost of finance, implications of taking the finance, legal implications, and many more. As of now, let’s drill down into the details of internal sources of finance.
What are Internal Sources of Finance?
- Internal sources of finance refer to the internally generated cash inflows through its business operations or fresh infusion of capital by the owners.
- As against the external source of finance in which cash flows manage through debt issues, bank loans, or lines of credit, the internal source of finance generates the cashflows without involving any external party.
- Internal finance sources generate through an entity’s usual course of operations. Thus, it characterizes as having no dependency on banks or lenders for building the company’s capital needs.
Examples of Internal Sources of Finance
Below are the different examples of Internal Sources of Finance:
1. Owner’s Investment
The owner is the person who owns the business and is thus responsible for keeping the business funded. These investments are through the personal income source of the owner. Investment by the owner is the true capital that stays in business unless the going concern assumption is compromised. No money comes into a business without cost finance. However, the owner does not charge interest for the funds infused. Instead, the owner takes a business risk and expects returns from the business. Concerning a corporate entity, this investment can be correlated with share capital.
2. Retained Profits
When the business is in an uptrend, huge cashflows are piling up. Profits of each year add to the reserves. The owners preferably withdraw these increased profits; rather, they are retained by the business for further expansion. Thus, if the business can provide higher returns than the expected return of the owner, the retained profits should never be drawn. Since the profits relate to the business, they need not be paid back. Increased retained profits increase the credit profile of the entity. Increased profits can use for more positive NPV (Net Present Value) projects of the entity, which may further amply the results. Concerning a corporate entity, this source of finance can correlate with reserves and surplus.
3. Issue of Stock
This option applies to listed entities where they can issue more stocks to the public through a further public offer. The offer document specifies the proposed utilization of the funds generated through an FPO. Accordingly, the company can specify the expansion of business as a purpose. The finance cost for this source of finance is the risk premium demanded by the shareholders.
4. Sale of the Operating Assets of an Entity
An entity can sell the old asset for partial funding to procure a new asset. A firm can decide to sell those operating assets on which repairs and maintenance expenses have increased exponentially. There is no cost of finance for this source of finance.
On the other side, the sale of operating assets as a source of finance is applicable for an entity soon to close the business. However, if the profits are high due to gain on the sale of operating assets, the earnings are lower quality. This is because gain on the sale of operating assets is not a sustainable source of income.
5. Leading the Debt Collection
Debt collection refers to realizing the sales proceeds via the sale of products or the provision of services. Normally a credit period offers to the customers. However, if the entity is under a cash crunch scenario, it should lead the sundry debtors. Leading the debt collection means tightening the credit period offered to customers. This source of finance comes with no cost of capital. However, delayed payment by customers may force the entity to take debt, leading to a higher financial cost.
6. Tightening the Operating Expenses
An entity may decide to reduce the unrequired business expenses. During the operations, the management may unknowingly incur many expenses, which can be avoided in general parlance. Savings on such expenses allows a company to control its cash budgets, and thus the saved cashflows can be used for internal purpose.
7. Horizontal Expansion of Business
Horizontal expansion means when a company starts producing and selling complementary goods and main products. This increases the sale of main products, and the increased economies of scale can use to profit from the sale of complementary goods.
Advantages of Internal Sources of Finance
- The business is run on owned funds rather than borrowed funds. Thus, there is no dominance of a third-party lender.
- Internal sources of finance are more flexible than external sources of finance.
- Business owners do not face financial risk and have to deal with financial risk only.
- If the entity had taken debt instead of an internal source of finance, the debt covenants may demand the entity to present the quarterly performance of the business. An entity funded through internal sources need not report a third party.
- Since no external funds are infused, the company maintains a good leverage ratio. Thus, the debt-equity ratio is at ground zero.
- The entity is no more dependent on bank loans or lines of credit and stays above in terms of a higher credit profile. Therefore, if such a company issues commercial papers shortly, the risk premium demanded by the investors would be lower.
Disadvantages of Internal Sources of Finance
- One cannot grow only using owned funds since the funds may be scarce. Debt is a double-edged sword. If an entity is low risk-averse, it should go for debt financing since capital costs are lower than equity funds.
- If there is no consistent increase in sales, the growth remains stagnated at the funds infused through internal sources. This is because the internal source of finance is limited and may not serve the funding needs of long-term projects.
- Debt is tax-deductible expenses. However, the dividend is not.
- Non-usage of external funds may limit the exposure of the business to external expertise.
Key Takeaways for Internal Sources of Finance
- Internal sources of finance refer to the internally generated cash inflows through its business operations or fresh infusion of capital by the owners.
- It is characterized by no dependency on banks or lenders for building the company’s capital needs.
- The classic examples of an internal source of finance include retained profits, sale of operating assets, issue of capital, and leading collection of debt.
- Business owners do not face financial risk and have to deal with financial risk only.
- Since no external funds infuse, the company maintains a good leverage ratio. Thus, the debt-equity ratio is at ground zero.
Conclusion
Internal funds provide confidence to owners that the business is growing faster and need not depend on external contributors to capital. However, a significant amount of idle funds is a big opportunity cost for any entity. Hence, such internal sources should be used to expand the business horizontally and vertically.
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