What are Internal Sources of Finance?

That is why internal sources of finance are the most preferred choice when it comes down to companies who would like to remain debt-free or do not want to pay a havoc charge on acquiring outside funding.

So, what are the examples of internal sources of finance? Let us have a look one by one.

Internal Sources of Finance Examples

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Example #1 – Profits and retained earnings

It is the most important internal source of finance, for example. We are considering it together because one is existent because of the other. For example, let us say that a company has no profits. Do you think that it can transfer anything to the retained earningsThe Retained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more? No.

Profits are the most important aspect of the business. Without profits, a company cannot think of internal sources of finance.

Let us take an example to illustrate this. An MNC company has not been generating any profits for a few years. The founders do not want to go into debt, so they use all their resources. But unfortunately, there have been no profits for the last few years. Suddenly, ABC Co. saw their work and decided to use the team at the MNC company. But to work on a project with an MNC company, one has to invest some money upfront. So what would MNC companies do?

Can they sell their assets? That would not be very reasonable since they would be out of business if this project did not work out. So, the better option is to go out to the bank and any financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more and try to fund the project using external sources of finance.

Now, let us talk about retained earnings. When the company makes profits, a portion, sometimes all of it (e.g., Apple in the beginning), is transferred for reinvestment into the companyReinvestment Into The CompanyReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio.read more. It is called “plowing back of profits” or “retained earnings.”

Let us look at a fictitious income statement and talk about profits and retained earnings: –

  • In the above example, “net income” can be used as an internal source. However, sometimes, one cannot reinvest the whole amount for many reasons (delayed payment of expenses, a small loan from relatives, etc.).

  • From this example, if you assume that 50% of the “net income” is reinvested, then $137,500 would be plowed back into the industry, and we can call it “retained earnings,” one of the most preferred sources of internal finance.

Example #2 – Sale of assets

Here is another example of an internal source of finance. Businesses sell off all sorts of non-current assetsNon-current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company’s investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more to finance the immediate requirement of capital. Companies that sell-off useful assets put themselves at a loss because they would not benefit from them once they are sold off.

But, is there a better option?

In essence, there are three options: –

  • Firstly, businesses can sell off old assets that they cannot use for a very long time. Selling off old assets will help enterprises fulfill the immediate requirement, and the businesses will also not leave out a lot of benefits.Secondly, the company can use the “sale and leasebackLeasebackLeaseback refers to a financial arrangement whereby the company that has sold the asset can take it back on lease from the buyer. Thus, the sale-leaseback facilitates the former owner to utilize the asset while its ownership lies with the purchaser. read more” approach. Under this approach, the company will get the cash for selling the asset, but at the same time, they will be able to use the property on a leaseLeaseLeasing is an arrangement in which the asset’s right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more.Thirdly, if selling off old assets does not serve the company, going for an external source of financeExternal Source Of FinanceAn external source of finance is the one where the finance comes from outside the organization and is generally bifurcated into different categories where first is long-term, being shares, debentures, grants, bank loans; second is short term, being leasing, hire purchase; and the short-term, including bank overdraft, debt factoring.read more is a better option (if there are no other internal sources of finance the company can use).

Example #3 – Reduction of working capital

It is also another example of internal sources of finance. Though it’s not used much, it can be valid if it needs a small amount of money immediately.

Such is also another example of internal sources of finance. Though it is not used much, it can be valid if it needs a small amount of money immediately. Such is also another example of internal sources of finance. Though it is not used much, it can be valid if it needs a small amount of money immediately.

A company can reduce the working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It’s a measure of a company’s liquidity, efficiency, and financial health, and it’s calculated using a simple formula: “current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)“read more in two ways –

  • A company can speed up the accounts receivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year.
  • read more cycle and stock.A company can lengthen the cycle of accounts payable.

Speeding up the stock/accounts receivable cycle will help them get the cash quickly. And prolonging the accounts payable cycle will keep the cash in the company for some time. As a result, a business can use this cash for its immediate requirement. Other than these, personal savings, employee contribution to the company, etc., can also be called internal sources of finance.

This article has been a guide to an internal source of finance. Here, we discuss the top 3 examples of the internal source of finance – profit and retained earnings, sales of assets, and working capital reduction. You may also go through the following recommended articles to learn more on corporate finance: –

  • InsourcingRetained Earnings FormulaBusiness Risk vs Financial RiskInternal and External Financing Differences