In the theory of

capital structure In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...

, internal financing or self-financing is using its profits or

asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...

s of a company or organization as a source of capital to fund a new

project A project is a type of assignment, typically involving research or design, that is carefully planned to achieve a specific objective. An alternative view sees a project managerially as a sequence of events: a "set of interrelated tasks to be ...

investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

. Internal sources of finance contrast with external sources of finance. The main difference between the two is that internal financing refers to the business generating funds from activities and assets that already exist in the company whereas external financing requires the involvement of a third party. Internal financing is generally thought to be less expensive for the firm than external financing because the firm does not have to incur

transaction costs In economics, a transaction cost is a cost incurred when making an economic trade when participating in a market. The idea that transactions form the basis of economic thinking was introduced by the institutional economist John R. Commons in 1 ...

to obtain it, nor does it have to pay the

taxes A tax is a mandatory financial charge or levy imposed on an individual or legal entity by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax co ...

associated with paying

dividends A dividend is a distribution of profits by a corporation to its shareholders, after which the stock exchange decreases the price of the stock by the dividend to remove volatility. The market has no control over the stock price on open on the ex ...

. Many economists debate whether the availability of internal financing is an important

determinant In mathematics, the determinant is a Scalar (mathematics), scalar-valued function (mathematics), function of the entries of a square matrix. The determinant of a matrix is commonly denoted , , or . Its value characterizes some properties of the ...

of firm investment or not. A related

controversy Controversy (, ) is a state of prolonged public dispute or debate, usually concerning a matter of conflicting opinion or point of view. The word was coined from the Latin '' controversia'', as a composite of ''controversus'' – "turned in an op ...

is whether the fact that internal financing is

empirically In philosophy, empiricism is an Epistemology, epistemological view which holds that true knowledge or justification comes only or primarily from Sense, sensory experience and empirical evidence. It is one of several competing views within ...

correlated In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistic ...

with investment implies firms are credit constrained and therefore depend on internal financing for investment. Studies show that the availability of funds within a company is a major driver for investment decisions. However, the success and growth of a company is almost entirely dependant on the financial management and the use of internal financing does not explicitly mean success or growth for the firm. The financial manager can use a range of sources including but not limited to

retained earnings The retained earnings (also known as plowback) of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point in time, such as at the end of the reporting period. At the end of that per ...

, the sale of assets, and the reduction and control of

working capital Working capital (WC) is a financial metric which represents operating liquidity available to a business, organisation, or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is consi ...

to drive expansion and better utilise funds. The availability of internal finance does not have a massive effect on firm growth.

Internal finance in practice

The specific source of internal financing used by a financial manager depends on the

industry Industry may refer to: Economics * Industry (economics), a generally categorized branch of economic activity * Industry (manufacturing), a specific branch of economic activity, typically in factories with machinery * The wider industrial sector ...

the firm operates in, the goals of the firm and the restrictions (financial or physical) that are placed on the firm. The sources of internal finance mentioned above can be used in conjunction with one another or individually. The mix of methods that the financial manager would choose also depends on several factors including the goals of the firm, their restrictions and their industry. For example, a

retail Retail is the sale of goods and services to consumers, in contrast to wholesaling, which is the sale to business or institutional customers. A retailer purchases goods in large quantities from manufacturers, directly or through a wholes ...

firm specialising in

consumer goods A final good or consumer good is a final product ready for sale that is used by the consumer to satisfy current wants or needs, unlike an intermediate good, which is used to produce other goods. A microwave oven or a bicycle is a final good. W ...

would generally not have as many

s as a car

manufacturer Manufacturing is the creation or Production (economics), production of goods with the help of equipment, Work (human activity), labor, machines, tools, and chemical or biological processing or formulation. It is the essence of the secondary se ...

. Therefore, the two firms would differ in that the retail firm would rely more on the reduction and control of working capital and retained earnings whereas the car manufacturer would generate more funds through the sale of assets (i.e., plant and equipment). A big downfall of internal financing revolves around the financial manager and their motives. Financial managers who control large internal sources of finance are more likely to seek investment opportunities that generate lower returns than shareholders can generate for themselves for the purpose of firm growth. Alternatively, managers who source funds externally are monitored closely by the

financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial marke ...

and therefore are inclined to act in the interest of shareholders.

Advantages

* By using internal sources of finance, the financial manager helps the company maintain ownership and control. If the company were to alternatively issue new

shares In financial markets, a share (sometimes referred to as stock or equity) is a unit of equity ownership in the capital stock of a corporation. It can refer to units of mutual funds, limited partnerships, and real estate investment trusts. Sha ...

to raise funds, they would be forfeiting a specific amount of control to their

shareholder A shareholder (in the United States often referred to as stockholder) of corporate stock refers to an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the ...

s. *The use of internal financing means no

legal obligation The law of obligations is one branch of private law under the civil law legal system and so-called "mixed" legal systems. It is the body of rules that organizes and regulates the rights and duties arising between individuals. The specific rights a ...

s to the company and lower costs. Legal obligations are irrelevant in the use of internal financing because the company has no obligation to pay or consult any third party. Costs are less because the cost of borrowing to raise funds through

debt financing Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Commer ...

is eliminated. *Internal financing helps improve (lower) the debt-to-equity ratio of a company making investments in the company attractive. *Capital is immediately available * No control procedures regarding

creditworthiness Credit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal sum, principal payment, leading to disrupted Cash flow, cash flows and increased Colle ...

* No influence of third parties * More flexibility

Disadvantages

* Internal financing is not ideal for long-term

s or accelerated growth. Internal financing limits a company's ability to borrow funds and therefore their growth is limited by the rate at which they can generate profits. *

Debt financing Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Commer ...

, a form of

external financing In the theory of capital structure, external financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment. T ...

, comes with the benefit of

tax deduction A tax deduction or benefit is an amount deducted from taxable income, usually based on expenses such as those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. The diff ...

s on the

interest In finance and economics, interest is payment from a debtor or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct f ...

payments made by the company. By choosing internal financing the company does not receive any tax benefits. *The use of internal finance limits a company's ability to expand its network. By limiting the potential expansion of a company's network, they miss out on potential benefits and external

expertise An expert is somebody who has a broad and deep understanding and competence in terms of knowledge, skill and experience through practice and education in a particular field or area of study. Informally, an expert is someone widely recognized a ...

* No increase of capital * Losses (shrinking of capital) are not tax-deductible * Limited in volume (volume of external financing as well is limited but there is more capital available outside - in the markets - than inside of a company)

Retained earnings

Retained earnings The retained earnings (also known as plowback) of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point in time, such as at the end of the reporting period. At the end of that per ...

is the most common source of internal financing for a company. Retained earnings are the

profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit (real property), a nonpossessory inter ...

s of a company that are not distributed to

s in the form of

dividend A dividend is a distribution of profits by a corporation to its shareholders, after which the stock exchange decreases the price of the stock by the dividend to remove volatility. The market has no control over the stock price on open on the ex ...

s, but rather are reinvested to fund new projects or ventures. Because retained earnings are reinvested rather than distributed in dividends, the company must insure that the

s they make, or the projects they fund using the earnings, yield a

rate of return In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment over a specified time period, such as i ...

that is equivalent to or higher than the rate of return that investors can generate by reinvesting those dividends that they could have received, all while maintaining the same level of risk. By failing to do so the financial manager may face adverse effects and risk losing shareholders which would lead to a decrease in company value. Funding Business Growth Internally

The reinvestment of earnings helps current shareholders in that it allows them to maintain the value of their shares. By sourcing the funds internally, a company would not need to issue new shares to raise capital through an

IPO An initial public offering (IPO) or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail (individual) investors. An IPO is typically underwritten by one or more investment ...

thus preventing the dilution of current shareholders' share values. Because retained earnings are funds that are already flowing through the company, the firm does not need to wait to receive those funds, meaning they are readily available for use. It is important to note that companies can do more than just reinvest their earnings or pay them out as dividends. When companies choose to pay out dividends, they only use between 50% and 70% of their earnings, the rest may be utilised elsewhere. Commonly, most firms rely heavily on internal financing, and retained earnings remains the most prominent form of financing for a firm. Shareholders in a firm are generally happy for retained earnings to be reinvested into the business as long as the projects that the funds are invested in produce a positive NPV. The reason for this is that any projects that are invested in which produce a positive NPV will subsequently increase a shareholders

wealth Wealth is the abundance of valuable financial assets or physical possessions which can be converted into a form that can be used for transactions. This includes the core meaning as held in the originating Old English word , which is from an ...

. If internal funds in the form of retained earnings are not enough to cover the cost of an investment then the company faces a financial deficit. In order to overcome this deficit the company would need to cut back on paying

s in order to increase their retained earnings or alternatively source their funds externally. Studies show that financial managers rely heavily on internal financing because they tend to avoid external financing based on

irrational Irrationality is cognition, thinking, talking, or acting without rationality. Irrationality often has a negative connotation, as thinking and actions that are less useful or more illogical than other more rational alternatives. The concept of ...

or self-serving fears. For example, by issuing new shares to raise capital the financial manager will be subject to the scrutiny of the financial market and may face awkward questions from potential

investor An investor is a person who allocates financial capital with the expectation of a future Return on capital, return (profit) or to gain an advantage (interest). Through this allocated capital the investor usually purchases some species of pr ...

Sale of assets

Sale of assets refers to a

company A company, abbreviated as co., is a Legal personality, legal entity representing an association of legal people, whether Natural person, natural, Juridical person, juridical or a mixture of both, with a specific objective. Company members ...

selling some or all of its

s in exchange for financial or physical gain. These assets can be

tangible Tangibility is the property of being able to be perceived, especially by the sense of touch. Metaphorically, something can also be said to be "cognitively tangible" if one can easily understand it. Law In criminal law, one of the elements of ...

(physical), intangible (financial), or a combination of both. The sale of assets is an essential aspect of internal financing and one of the more common sources of

financing Funding is the act of providing resources to finance a need, program, or project. While this is usually in the form of money, it can also take the form of effort or time from an organization or company. Generally, this word is used when a firm use ...

for a company. The assets which a company can sell are not limited. It is down to the financial manager to strategise and decide what assets are to be sold, physical or financial, and the decision is based on either company growth or downsizing. The sale of assets, through a theoretical perspective, is viewed as a way to increase asset

efficiency Efficiency is the often measurable ability to avoid making mistakes or wasting materials, energy, efforts, money, and time while performing a task. In a more general sense, it is the ability to do things well, successfully, and without waste. ...

or raise capital. By increasing asset efficiency, which is done through asset reallocation, companies can take advantage of

economic An economy is an area of the Production (economics), production, Distribution (economics), distribution and trade, as well as Consumption (economics), consumption of Goods (economics), goods and Service (economics), services. In general, it is ...

changes and increase their value. This is different to the sale of assets which serves the purpose of generating capital. Both are valid approaches in which a company can initiate growth. As the business in itself is an asset, a part of the business can be sold to an investor in exchange for

cash In economics, cash is money in the physical form of currency, such as banknotes and coins. In book-keeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-i ...

. Shares in the company may be sold on the share market. For

small business Small businesses are types of corporations, partnerships, or sole proprietorships which have a small number of employees and/or less annual revenue than a regular-sized business or corporation. Businesses are defined as "small" in terms of being ...

es, this can be done through the addition of a

business partner A business partner is a commercial entity with which another commercial entity has some form of alliance. This relationship may be a contractual, exclusive bond in which both entities commit not to ally with third parties. Alternatively, it may be ...

where an individual pays the business owner a specified amount of money in exchange for a specified degree of control within the business. The sale of assets can produce short-term and long-term finance dependent on the type of asset sold. The sale of equipment which has become obsolete or is outdated is a source of short-term internal financing. Regular screening of the

fixed asset Fixed assets (also known as long-lived assets or property, plant and equipment; PP&E) is a term used in accounting for assets and property that may not easily be converted into cash. They are contrasted with current assets, such as cash, bank ac ...

register aids in finding assets which are no longer being used and can be sold, usually at a loss, in order to satisfy financial needs. The sale of more substantial assets such as

building A building or edifice is an enclosed Structure#Load-bearing, structure with a roof, walls and window, windows, usually standing permanently in one place, such as a house or factory. Buildings come in a variety of sizes, shapes, and functions, a ...

land Land, also known as dry land, ground, or earth, is the solid terrestrial surface of Earth not submerged by the ocean or another body of water. It makes up 29.2% of Earth's surface and includes all continents and islands. Earth's land sur ...

and

machine A machine is a physical system that uses power to apply forces and control movement to perform an action. The term is commonly applied to artificial devices, such as those employing engines or motors, but also to natural biological macromol ...

ry can be used as a source of long-term internal financing as those assets often produce an increased financial gain. If the business sells off useful assets or assets that are still within their useful life, they can put themselves at a loss as they would no longer receive any benefit from that asset.

Reduction and control of working capital

Reduction and control of

both fall under the management of working capital. According to Sagner "Working capital management involves the

organisation An organization or organisation ( Commonwealth English; see spelling differences) is an entity—such as a company, or corporation or an institution ( formal organization), or an association—comprising one or more people and having a pa ...

of a company's short-term

resource ''Resource'' refers to all the materials available in our environment which are Technology, technologically accessible, Economics, economically feasible and Culture, culturally Sustainability, sustainable and help us to satisfy our needs and want ...

s to sustain on-going activities, mobilise funds, and optimise

liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quic ...

." Working capital is a complex concept that can be described as the difference between the

current asset In accounting, a current asset is an asset that can reasonably be expected to be sold, consumed, or exhausted through the normal operations of a business within the current fiscal year, operating cycle, or financial year. In simple terms, current ...

s of a company and their

current liabilities Current liabilities in accounting refer to the liabilities of a business that are expected to be settled in cash within one fiscal year or the firm's operating cycle, whichever is longer.Drake, P. P., ''Financial ratio analysis'', p. 3, publish ...

. By managing and controlling working capital the financial manager can reallocate and restructure funds to provide the capital that the company requires from an internal source. Working Capital is a measure of a firm's ability to meet its short-term financial obligations, the firm's

or lack-off in business operations and short-term financial strength. If current assets outweigh current liabilities, the firm has positive working capital and their ability to

invest Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

and grow increases. If current liabilities outweigh current assets, the firm has negative working capital and the ability to invest and grow is decreased along with the ability to pay back

debt Debt is an obligation that requires one party, the debtor, to pay money Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...

s that are outstanding. A business can reduce their working capital through the enhancement of receivables and payables accounts. Speeding up the cycle of

accounts receivable Accounts receivable, abbreviated as AR or A/R, are legally enforceable claims for payment held by a business for goods supplied or services rendered that customers have ordered but not paid for. The accounts receivable process involves customer on ...

means the company can generate cash quickly by acquiring cash flows and profits they are set to receive, before they are expected to be collected. Lengthening of

accounts payable Accounts payable (AP) is money owed by a business to its suppliers shown as a liability on a company's balance sheet. It is distinct from notes payable liabilities, which are debts created by formal legal instrument documents. An accounts payable ...

can aid in the reduction of working capital through delayed payments. This means the business can free up working capital to be used as a source of internal financing by delaying payments relating to the reduction of debt arising from accounts which are payable by the business.

References

External links

Definition at investor words.
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