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.

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.

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.

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.

#1 - 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.

#2 - 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.

#3 - 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.

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

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 earnings? 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 institution 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 company. 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 assets 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 leaseback” 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 lease.
• Thirdly, if selling off old assets does not 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

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 capital in two ways –

• A company can speed up the accounts receivables 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.

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: