What is Internal Sources of Finance?
Internal sources of finance refer to generating finance for the company internally from sources like revenue generated from sales, collection of debtors or loan advanced, retained profits to cover the operating expenses of company or cash required for investment, growth and further business.
That’s why internal sources of finance are the most preferred choice when it comes down to companies who would like to remain debt-free or don’t want to pay a havoc charge on acquiring outside funding.
So, what are the examples of internal sources of finance? Let’s have a look one by one.
Internal Sources of Finance Examples
Example #1 – Profits and retained earnings
This is the most important internal source of finance for example. We are considering it together because one is existent because of the other. Let’s 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.? No.
Profits are the most important aspect of business. Without profits, a business can’t think of internal sources of finance.
Let’s take an example to illustrate this. MNC Company has not been generating any profits for a few years. The founders don’t want to go in debt, so they try to make use of all their resources. But unfortunately, there are no profits for the last few years. Suddenly, ABC Company saw their work and decided to use the team at MNC Company. But to work on a project with MNC Company has to invest some money upfront. What would MNC companies do?
Can they sell their assets? That would be foolish since if this project doesn’t work out, they would be out of business. The better option is to go out to the bank and to 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. and try to fund the project using external sources of finance.
Now, let’s 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.. This is called “plowing back of profits” or “retained earnings”.
Let’s look at a fictitious income statement and talk about profits and retained earnings –
|Details||2016 (In US $)|
|Gross Sales (Revenue)||30,00,000|
|(-) Sales Returns||(50,000)|
|(-) Cost of Goods SoldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. (COGS)||(21,00,000)|
|Selling ExpensesSelling ExpensesThe amount of money spent by the sales department on selling a product is referred to as selling expenses. This includes expenses incurred on advertising, distribution and marketing. Because it is indirectly related to the production and delivery of goods and services, it is classified as an indirect cost.||220,000|
|Total Operating Expenses||(400,000)|
|Operating Income (EBIT)||450,000|
|Profit before Income Tax (PBT)||400,000|
|Net Income (PAT)||275,000|
- In the above example, “net income” can be used as an internal source. Sometimes, the whole amount can’t be reinvested for many reasons (delayed payment of expense, a small loan from relatives, etc.).
- From this example, if you assume that 50% of the “net income” is reinvested in the business, then $137,500 would be plowed back in the business and we can call it “retained earnings” and one of the most preferred sources of internal finance.
Example #2 – Sale of assets
This 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. to finance the immediate requirement of capital. Businesses that sell-off useful assets put themselves at a loss because once these useful assets are sold off; the businesses wouldn’t be able to receive any benefit from them.
But, is there a better option? There are three options.
- Firstly, businesses can sell off old assets that they can’t use for a very long time. Selling off old assets will help businesses in fulfilling the immediate requirement and the businesses will also not leave out a lot of benefits.
- Secondly, the company can use the approach to “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. ”. 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 asset 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.”.
- Thirdly, if selling off old assets doesn’t serve the company, going for an external source of finance is a better option (if there are no other internal sources of finance the company can use).
Example #3 – Reduction of working capital
This is also another example of internal sources of finance. Though it’s not used much, it can be valid if the company 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)" in two ways –
- A company can speed up the cycle of accounts receivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. and stock, or,
- A company can lengthen the cycle of accounts payable.
Speeding up the stock/accounts receivable cycle will help them get the cash quickly. And lengthening 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 as internal sources of finance.
This has been a guide to what is 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 Reduction of working capital. You may also go through the following recommended articles to learn more on Corporate Finance –