Internal Sources of Finance

Updated on April 4, 2024

What Are 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 advances, retained profits to cover the operating expenses of the company or cash required for investment, growth, and further business.

Internal Sources of Finance

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Being readily available to a business and having the ability to be derived from assets no longer in use, these internal sources of finance are the most preferred choice. They differ from external sources of finance, which not only makes businesses obligated to repay the external sources, be it friends, relatives, banks, or other entities, but also involve payment of havoc charges applicable to acquiring outside funding.

Key Takeaways

  • Internal sources of finance mean creating internal finance for the company, such as revenue from sales, collection of debtors or loan advances, retained profits to cover the company’s operating expenses, or cash required for investment, growth, and more business.
  • Examples of internal sources of finance include profit and retained earnings, asset sales, and working capital reduction.
  • Profits are an essential business aspect. A company must have profits to think of internal sources of finance.
  • Businesses sell off non-current assets to finance the immediate capital requirement.

Internal Sources of Finance Explained

Internal sources of finance for a business are the most convenient resources that help boost the activities and operations of a firm. As the name itself suggests, these sources are those available with the firm already and do not need to be arranged using external entities or players.

The internal sources of finance include the resources available to the businesses, including the best utilization of assets that are no longer in use. These also include the investments of the owner or profits made by the businesses. In short, these sources include all resources, monetary and non-monetary, which are available without any external involvements. This means that when businesses have resources not coming from an external element or origin, they become the internal source of finance.

The internal sources allow businesses to not be involved in any kind of financial obligations from another party. The businesses arrange for funds internally without taking aid from investors or other businesses. As a result, they do not have to shoulder the burden of paying back an external source. Instead, they use their own things, sell off the required assets, and generate cash from whatever is available to them.

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Types

When it comes to the types of internal sources of finances, the most common of them all are – retained profits, owner’s funds, and selling unwanted assets.

Retained profits

Retained profits are the money generated by a business. This is the profits that the companies are left with after distributing the shares to the shareholders in the form of dividends. This profit is easily used to advance businesses without taking favors from external sources.

Owner’s funds

The owners have resources available to invest in their businesses and take care of the expenses that the businesses may incur from time to time. Hence, the owner can use their savings or finances meant for their business to ensure growth and progress.

Sale of unwanted assets

At times, there are assets in a business that are no longer in use. Such assets can be sold when required to generate finances to ensure the advancement of the business.

Examples

Let us consider the following examples to understand the internal sources of finance definition better and in more details.

Example #1 – Profits and retained earnings

Internal Sources of Finance - 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: –

Details2016 (In US $)
Gross Sales (Revenue)30,00,000
(-) Sales Returns(50,000)
Net Sales29,50,000
(-) 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. read more (COGS)(21,00,000)
Gross Profit850,000
General Expenses180,000
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.read more220,000
Total Operating Expenses(400,000)
Operating Income (EBIT)450,000
Interest expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more(50,000)
Profit before Income Tax (PBT)400,000
Income Tax(125,000)
Net Income (PAT)275,000
  • 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

Internal Sources of Finance - 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: –

Example #3 – Reduction of working capital

Internal Sources of Finance - reduction in 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 –

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.

Advantages and Disadvantages

Sourcing business growth using internal funds allows businesses to be free from financial obligations. At the same time, it poses a few risks as well.

Below is a list of benefits and limitations of using internal sources of finance:

AdvantagesDisadvantages
No external costs, like interest rates, etc., are involved.Funds are limited
No external control is exercised as no external source of finance is involved.Liquidity gets reduced
Immediate availabilityEarnings get minimized as money generated is used for growth purposes.
No legal liabilities involved 

Frequently Asked Questions (FAQs)

What internal sources of finance do not include?

The internal sources of finance do not include funds raised from external sources like banks, new shareholders, friends, family, suppliers, government, etc.

What are internal vs external sources of finance?

Internal source of finance refers to the finance coming from the business. In comparison, an external source of finance comes from external investors such as shareholders or lenders who may expect either a business percentage or interest paid in exchange.

What is the importance of internal sources of finance?

The financial manager may help the company maintain ownership and control using the internal source of finance. For example, suppose the company issues new shares to raise funds; alternatively, they would lose a specific power to their shareholders.

Why internal sources of finance are preferred to external sources?

The internal sources of finance are economical and expensive. Therefore, it does not need collateral for raising funds. On the contrary, assets are sometimes mortgaged as security to boost funds from external sources of finance.

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This article has been a guide to what are Internal Sources of Finance. Here, we explain the concept with examples, advantages, disadvantages, and types. You may also go through the following recommended articles to learn more on corporate finance: –

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