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Internal Sources of Finance | Top 3 Examples

Internal source of finance

What is Internal Sources of Finance?

Internal sources of Finance are the sources of funds inside the business that are readily available. If a business needs to invest into a project right now, the company can decide to put in the money by selling an old asset of the business. It’s simple, it’s easy, and the company doesn’t need to put in a lot of effort to do that.

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

Internal Sources of Finance - Retained Earnings

source: Colgate SEC Filings

This is the most important internal sources of finance 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 earnings? No.

Profits are the most important aspect of the 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 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 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 Company 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 institution 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 company. 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)
Net Sales 29,50,000
(-) Cost of Goods Sold (COGS) (21,00,000)
Gross Profit 850,000
General Expenses 180,000
Selling Expenses 220,000
Total Operating Expenses (400,000)
Operating Income (EBIT) 450,000
Interest expenses (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. 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

Internal Sources of Finance - Sale of Assets

source: Yahoo SEC Filings

This is another example of internal source of finance. Businesses sell off all sorts of non-current assets to finance the immediate requirement of capital. Businesses which sell off useful assets put themselves at 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 which they can’t use for 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 “sell and lease back”. 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 lease.
  • 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

Internal Sources of Finance - reduction in working capital

source: kennametal.gcs-web.com

This is also another example 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 capital by two ways –

  • A company can speed up the cycle of accounts receivables 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.

Recommended Articles

This has been a guide to what is Internal Source of Finance. Here we discuss the Top 3 examples of 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 –

  • Internal vs External Financing | Top 7 Differences (Infographics)
  • Revenue Reserve
  • Capital Reserve
  • Business Risk | Top 4 Types of Business Risk

The post Internal Sources of Finance | Top 3 Examples appeared first on Learn Investment Banking: Financial Modeling Training Courses Online.



This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here

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