In the theory of capital structure, internal financing is the process of a

firm A company, abbreviated as co., is a legal entity representing an association of people, whether natural, legal or a mixture of both, with a specific objective. Company members share a common purpose and unite to achieve specific, declared go ...

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 ...

s as a source of capital to fund a new project or investment. 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 and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike pro ...

to obtain it, nor does it have to pay the

taxes A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, o ...

associated with paying dividends. Many economists debate whether the availability of internal financing is an important

determinant In mathematics, the determinant is a scalar value that is a function of the entries of a square matrix. It characterizes some properties of the matrix and the linear map represented by the matrix. In particular, the determinant is nonzero if a ...

of firm investment or not. A related controversy is whether the fact that internal financing is

empirically In philosophy, empiricism is an epistemological theory that holds that knowledge or justification comes only or primarily from sensory experience. It is one of several views within epistemology, along with rationalism and skepticism. Empir ...

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 Financial management is the business function concerned with profitability, expenses, cash and credit, so that the "organization may have the means to carry out its objective as satisfactorily as possible;" the latter often defined as maximizin ...

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 of time, such as at the end of the reporting period. At the end of that peri ...

, 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 sale to business or institutional customers. A retailer purchases goods in large quantities from manufacturers, directly or through a wholesaler, and ...

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 a intermediate good, which is used to produce other goods. A microwave oven or a bicycle is a final good, b ...

would generally not have as many

s as a car

manufacturer Manufacturing is the creation or production of goods with the help of equipment, labor, machines, tools, and chemical or biological processing or formulation. It is the essence of secondary sector of the economy. The term may refer to ...

. 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 market ...

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

Advantages & Disadvantages of Internal Financing

Internal financing - like all other business functions - has advantages and disadvantages, they are as follows;

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 to raise funds, they would be forfeiting a specific amount of control to their shareholders. *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 is eliminated. *Internal financing helps improve (lower) the

debt-to-equity ratio The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two ...

of a company making investments in the company attractive. *Capital is immediately available * No control procedures regarding

creditworthiness A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...

* No influence of third parties * More flexibility

Disadvantages

* Internal financing is not ideal for long-term projects 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, 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 Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. T ...

s on the

interest In finance and economics, interest is payment from a borrower 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 distin ...

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 Network, networking and networked may refer to: Science and technology * Network theory, the study of graphs as a representation of relations between discrete objects * Network science, an academic field that studies complex networks Mathematics ...

. 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. Informally, an expert is someone widely recognized as a reliable s ...

* 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 of time, such as at the end of the reporting period. At the end of that peri ...

is the most common source of internal financing for a company. Retained earnings are the profits of a company that are not distributed to shareholders in the form of

dividend A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-i ...

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 investments 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, such as interest payments, coupons, cas ...

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 I ...

. 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 inclusion of rationality. It is more specifically described as an action or opinion given through inadequate use of reason, or through emotional distress or cognitive deficiency. T ...

or self-serving fears. For example, by issuing new shares to raise capital the financial manager will be subject to the

scrutiny Scrutiny (French: ''scrutin''; Late Latin: ''scrutinium''; from ''scrutari'', meaning "those who search through piles of rubbish in the hope of finding something of value" and originally from the Latin "scruta," meaning "broken things, rags, or ...

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 (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...

Sale of Assets

Sale of assets refers to a company 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 by touch. A commonplace understanding of "tangibility" renders it as an attribute allowing something to be perceptible to the senses. In criminal law, one of the elements of an offense ...

(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 A theory is a rational type of abstract thinking about a phenomenon, or the results of such thinking. The process of contemplative and rational thinking is often associated with such processes as observational study or research. Theories may be ...

perspective, is viewed as a way to increase asset efficiency 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, distribution and trade, as well as consumption of goods and services. In general, it is defined as a social domain that emphasize the practices, discourses, and material expressions associated with the ...

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 bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-im ...

. Shares in the company may be sold on the share market. For small businesses, 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 contract A contract is a legally enforceable agreement between two or more parties that creates, defines, an ...

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 A fixed asset, 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. Fixed assets are different from current assets, such as cash ...

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 with a roof and walls standing more or less permanently in one place, such as a house or factory (although there's also portable buildings). Buildings come in a variety of sizes, shapes, and fu ...

land Land, also known as dry land, ground, or earth, is the solid terrestrial surface of the planet Earth that is not submerged by the ocean or other bodies of water. It makes up 29% of Earth's surface and includes the continents and various isla ...

and machinery 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, an institution, or an association—comprising one or more people and having a particular purpose. The word is derived from ...

of a company's short-term

resource Resource refers to all the materials available in our environment which are technologically accessible, economically feasible and culturally sustainable and help us to satisfy our needs and wants. Resources can broadly be classified upon their ...

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, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Liq ...

." Working capital is a complex concept that can be described as the difference between the current assets of a company and their

current liabilities In accounting, current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer. A more complete definition is t ...

. 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 efficiency 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 the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...

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 or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

s that are outstanding. A business can reduce their working capital through the enhancement of

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. These are generally in the form of invoices raised b ...

s 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. These are generally in the form of invoices raised ...

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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