What are Internal Finance / Internal Sources of Finance?
The term “internal finance” (or internal sources of finance) itself suggests the very nature of finance/capital. This is the finance or capital generated internally by the business, unlike finances such as loans that banks or financial institutions externally arrange. The internal source of finance is retained profits, the sale of assets, and the reduction/control of working capital.
Finance is a constant requirement for every growing business. There are several sources of finance from which 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 regarding cost, availability, eligibility, legal boundaries, etc. Choosing the 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.
- What are Internal Finance / Internal Sources of Finance?
- Retained Profits / Retained Earnings
- Sale of Assets
- Reduction or Controlling of Working Capital
Internal sources of finance are the sources of finance or capital for businesses generated by the business itself in its ordinary course of operations.
The key characteristic is that there is no outside dependency for catering to capital needs. Internal sources of finance are:
Retained Profits / Retained Earnings
Retained profits/earnings are called the internal source of finance for a business because 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
It is as shown below:
Retained Profits / Retained Earnings = Net Profits – Dividend / Drawings
Characteristics of Retained Profits
Retained earnings are a long-term source of finance for a company because there is no compulsory maturity like term loans and debentures.
Retained profits are not characterized by the fixed burden of interest or installment payments like borrowed capital.
Advantages and Disadvantages of Retained Profits as an Internal Source of Finance / Capital
Advantages of Retained Earnings as an Internal Source of Finance
The advantage of having retained profits/earnings is 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 because there is no issue cost attached to it, ranging between 2 – 3 %.
- Lastly, investing retained earnings in the projects, with IRR better than the ROI of the business, will directly have a positive impact on the shareholder’s wealth, and thereby the core objective of management will be served.
Disadvantages of Retained Earnings as an Internal Source of Finance
There is practically no disadvantage in generating or using retained earnings to finance the business’s investments. Assuming that the funds generated internally are not free as they belong to the shareholders, the cost of these funds is equal to the cost of equity. There is only one alternative that can be explored, i.e., debt financing sources. Exploring the option leads to thinking about two points—one, financial leverage that can be gained by introducing debt financing. Second, if the leverage is possible and practical, a dividend decision regarding using the retained earnings to pay dividends to shareholders can be explored.
Sale of Assets
Another internal source of finance is the sale of assets. Whenever a 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 by the sale of assets.
Advantages of Generating Finance by 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 to short-term and smaller finance needs, and selling land, buildings, or machinery can cater to long-term and bigger finance needs.
Secondly, it is good to regularly screen the fixed asset register and find assets that are no longer in use or are already obsolete, etc. These assets should be sold as early as any such event happens so that dilution in the value of such assets would be less.
Disadvantages of Generating Finance by Sale of Assets
A major drawback of this type of capital is when the assets are sold before their useful life. Apart from losing on the services provided by the sold asset, there is a loss in capital loss due to the asset being sold at scrap value. 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 the current financial 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 two components. First, current assets include stock/inventory, account receivables – Debtors, and cash/bank balances. Second, current liabilities include account payables – creditors and bank overdraft.
How to Generate Finance by Reduction of Working Capital?
Usually, a business requires two types of finance: long-term finance for capital expenditure and working capital finance for day-to-day needs. Reduced working capital can be achieved either by speeding up the cycle of account receivables and stock or lengthening the cycle of account payables.
Speeding Up Accounts Receivables
Trade credit is an unavoidable event for any business barring a few. A finance manager should make strategies to speed up the collection of money from accounts receivables.
Lengthening of Accounts Payables
Negotiating good terms with accounts payables can finance part of the trade finance required for customers.
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 from the efficient management of working capital and the appropriate usage of working capital management techniques.
Advantages of Reducing Working Capital
The advantages of reducing the working capital are manifold. The primary benefit is savings on the interest cost paid on working capital loans, bank overdrafts, cash credit, etc. Some of the many secondary benefits which are achieved while in the process of reducing the working capital are
- Of course, savings on interest cost
- efficient overall working capital management,
- streamlined operations of the business,
- savings on bank charges, etc.
For an in-depth understanding, we recommend reading
Disadvantages of Reducing Working Capital
Risk of Bankruptcy
Although it is challenging to locate any disadvantage of reducing working capital, the risk of bankruptcy rises in an attempt to reduce the working capital to a very low level. So, we recommend optimizing the working capital in place of reducing it. You may consider reading the following:
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 financial requirements of the company and the personal savings of the owners.
A finance manager would often try sourcing funds from internal sources because of the benefits stated above. Businesses using an internal source of financing also show good performance as the business independently satisfies its requirements with the help of its efficiencies and operational profits.
Quiz on Internal Sources of Finance
Let’s take a quick test on the topic you have read here.
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