1. ACKNOWLEDGEMENT 2. DEFINITION 3. DIFFERENCE BETWEEN INTERNAL AND EXTERNAL FINANCE 4. INTERNAL SOURCES OF FINANCE 5. ADVANTAGES AND DISADVANTAGES OF INTERNAL FUNDING 6. BIBLIOGRAPHY
I have taken efforts in this project. However, it would not have been possible without the kind support and help of many individuals and others. I would like to extend my sincere thanks to all of them. I am highly indebted to H.R College and the teaching faculty for their guidance and constant supervision as well as for providing necessary information regarding the project and also for their support in completing the project. I would like to express our gratitude towards my parents, fellow friends and the teacher for their kind co-operation and encouragement which helped me in completion of this project. My thanks and appreciations also goes to all those who have in some ways helped me in developing the project and people who have willingly helped me out with their abilities.
Internal funds are funds that are raised within a firm. For example, income after taxes and non-cash expenses, such as depreciation, provide a firm with funds to use in the acquisition of investments. Companies that are able to finance expenditures with internal funds are not required to rely on borrowing or the sale of additional shares of stock. Internal finance is also known as self-financing by a company. Internal finance includes the funds generated within the corporate unit irrespective of the nature of source. In other words the extent of profitability after tax, the size of dividend payments and the amount of depreciation provided for along with the reserves and surplus all contribute to the sources of internal funds and these funds can be used by a company financing the cost for acquisition of fixed assets, expansion modernization or diversification, etc. There exists a controversy whether depreciation should be taken as a source of funds. Whatever may be the outcome of such controversy, the fact remains that the depreciation is a sum that is set apart out of profits and retained within the business and finance the capital needs in the normal business routine, and as such depreciation in true academic sense be deemed as a source of internal finance. Sources of Total Finance Paid up capital - Equity and - Preference Reserves and surplus - including Share Premium Secured Loans Unsecured loans Current Liabilities and Provisions Sources of Internal Finance Bonus issue of shares paid-up Bonus issue of preference shares Reserves and Surpluses Provision including provisions depreciation.
Amongst all the sources of internal finance, main source is depreciation on an average as revealed by some research studies done by research scholars. The second source is reserves and surplus and lastly the bonus issue of preference shares or equity shares. As regards depreciation, the term denotes the funds set apart for replacement of worn-out assets. Depreciation is a deduction out of profits of the company calculated as per accounting rules on the basis of estimated life of each assets each year to total over the life of the assets to an amount equal to to original value of the assets. Although depreciation is meant for replacement of particular assets but generally it creates a pool of funds which are available with a company to finance its working capital requirements and sometimes for acquisition of new assets including replacement of worn-out plant and machinery. Depreciation is an expenditure recorded in the accounting system of a company and is allowed to be deducted while arriving at the net profits of the companysubject to adherence of the percentages of allowable depreciation fixed under the tax laws.
Surplus are total sum of the left overs from various accounts in the accounting system of a company i.e. the "surplus" is the remaining part of the net income after distribution of dividends to the shareholders. A company is required to transfer 10% of the profit to reserves while declaring divident which could be more depending upon the profitability of the company. A company can distribute dividend out of the surplus but according to the rules as prescribed from time to time by the Government. Surplus is accumulated from other sources besides the remainder of earned income which are known as capital surplus and surplus arising from revaluation of assets. The entire surplus belongs to the equity holder as part of the net worth. The main source of surplus remain the net profits from operations at a close of accounting period, past accumulated profits, conversion of unnecessary reserves, and non operating income. Surplus remains an important source of capital for both newly promoted companies and established companies. Surplus adds to the credit standing of newly promoted company to establish a market price for its equity shares. For an established company it becomes source of finance for comparison / diversification motivated schemes. Surplus also supplements the reserves. Reserve, surplus and provisions, both form good sources of financing internally the development programmes within the company without much depending upon outside funds through borrowing. They meet the fixed and working capital requirements within the industry. Internal financing through utilisation of company's own funds is also known as ploughing back of profits. Besides, internal funds help the company in number of ways viz 1. Achieve a suitable dividend policy and enlisting the support of the public; 2. It helps internal finance of projects without resumption of borrowings; 3. Deficiencies in liability and reserves are fulfilled out of the retained income; 4. It is used for retiring bond or debentures for building up sinking funds for redemption of debt. Thus, reserves and surplus add to the capital formation at micro level. The main determinants of internal funds are corporate earnings, taxation and corporate savings, and the dividends policy of the company.
DIFFERENCE BETWEEN INTERNAL AND EXTERNAL FUNDING
To provide internal and external finance means to engage in business activities using either monies from within a company or funds from outside. This is the key and most important difference between these two funding options. When a company uses internal finance, it takes advantage of existing supplies of capital from profits and other sources. External finance involves the use of money new to the company, from outside sources, to fund planned activities. External finance requires either going into debt or giving up control. Companies can borrow money in a variety of ways, take shares public, or solicit venture capitalists to invest directly. All of these can compromise a company and highlight the difference between internal and external finance. For one, the company has limited flexibility and high control, and with the other, companies have flexibility, but must give up control in order to access it. Companies
with publicly traded shares, for instance, are vulnerable to takeover. Differences between internal and external finance can determine how a company proceeds with business decisions. Sources of external funding can be limited if a company does not seem like a good investment prospect or appears to be a poor credit risk. This can limit opportunities for external finance, as a company might not be willing to pay high interest or take other trade-offs to access capital. Internal finance is limited to what a company can raise on its own, and how much liquidity it is willing to sacrifice to bring a given project to completion. Liquidity can be a substantial issue if projects cost more than companies expect, as they may end up dedicating additional internal funds that they won't be able to access rapidly.
Consultants can provide advice on internal and external finance for companies that are not sure about which would be most appropriate or effective for a given application. The consultant can review financial documentation and the planned activity to offer balanced advice. For some firms, it may make more sense to keep funding internal while others may benefit from external sources of capital, and would not be at risk from the increased debt or loss of control.
INTERNAL SOURCES OF FINANCE
Definition These are sources of finance that come from the business' assets or activities.
Retained Profit If the business had a successful trading year and made a profit after paying all its costs, it could use some of that profit to finance future activities . This can be a very useful source of long term finance, provided the business is generating profit (see section on profit & loss accounts).
Sale of Assets
The business can finance new activities or pay-off debts by selling its assets such as property, fixtures & fittings, machinery, vehicles etc. It is often used as a short term source of finance (e.g. selling a vehicle to pay debts) but could provide more longer term finance if the assets being sold are very valuable (e.g. land or buildings) If a business wants to use its assets, it may consider sale and leaseback where it may sell its assets and then rent or hire it from the business that now owns the assets. It may mean paying more money in the long run but it can provide cash in the short term to avoid a crisis.
Reducing Stocks Stock is a type of asset (see balance sheet work for more on assets) and can be sold to raise finance. Stock includes the business' holdings of raw materials (inputs), semi-finished products and also finished products that it has not yet sold. Businesses will usually hold some stock. It can be useful if there is an unexpected increase in demand from customers. Stock levels tend to rise during economic slowdowns or recessions as goods are not sold and 'pileup' instead. It is not usually a source of large amounts of finance - if a business has very large stock piles, it might mean that nobody wants to buy the product and reducing stocks will therefore be hard. It is often considered to be a short term source.
A business does not normally pay for things before it takes possession of them. Instead, it will usually place an order for supplies / inputs and will pay after receiving the items. It is good practice to pay quickly (often within one month) as this will help the business develop a good relationship with its suppliers. This source of finance appears on the balance sheet as trade credit. This method of deferring (delaying) payment to a future date is a form of very short term borrowing and helps with the problems of the cash cycle identified in the work on liquidity.
Companies need financing for short- and long-term operating requirements, working capital needs, expansion programs and investments in new markets or product research. They may need funding for corporate re-organization projects such as mergers and acquisitions. Entities use internal financing sources if they are unable to receive external investments from lenders, or such external investors require high interest rates on loans.
Internal Funding vs. Bank Financing When you use company funds, you do not have to pay interest to the bank. You also do not have to go through the application process, which can be costly if you have to pay someone to prepare profit and loss statements, balance sheets and other documentation required by the bank. Internal Funding vs. Selling Stock One way to raise money for your business projects is to sell stock to investors. This gives them part ownership of the company. Using internal funding offers the advantage of keeping control in the hands of the company's founders. Internal Funding vs. Government Grants A business may qualify for government grants under certain circumstances. Minority grants can help minority-owned businesses expand, and businesses can receive grants for going green, to name just two examples. However, the application process can be lengthy and expensive. The expense comes from preparing the documentation for these grants. You have to win the approval of the agency giving the grant, and this can involve many individuals and committees. With internal funding, you can start on your project immediately, with no approval required other than that of management and your stockholders. Internal Funding vs. Selling Assets Some businesses try to fund new expenditures by selling assets. This decreases the value of the company and can trigger transaction costs, as well as taxes. Internal funding keeps all assets in the company and incurs no additional expenses beyond the cost of the project itself.
ADVANTAGES AND DISADVANTAGES OF INTERNAL FUNDING
ADVANTAGES For your small business to grow, you have to spend money. Whether it's additional advertising, new equipment, expanded facilities, or a new department you want to add, you will need to fund your effort. You have two choices for this funding: external sources and internal sources. Learn the advantages of using internal sources to fund your expansion, and you will be on your way to a sustainable growth for your business. Decision-Making Freedom
When you finance your business activities internally, you are not accountable to any outside entity. You don't need to explain your business decisions to anyone outside your company or seek their approval before making changes or expanding. This decision-making freedom enables you to weigh personal as well as financial considerations when choosing the right course of action for your business. For example, if you have financed your business internally and you find yourself feeling drained and depleted, you can make the decision to take some time off or hire someone to replace yourself temporarily, even if this is not the wisest path from a strictly objective financial standpoint. If you were accountable to an outside financial entity, it might be more difficult to take care of your personal needs because they would probably pressure you to consider only the financial health of the business. Flexibility
Internal financing allows you considerably more flexibility than outside sources of capital. If you finance your business internally and you experience a slow period that makes it difficult for you to repay a loan according to the schedule you have outlined, you can simply make an extra payment the next month. With internal financing it is usually easy to adjust payment terms in accordance with your current business cash flow and other unanticipated circumstances. Credit Score Consequences
If you finance your business internally and have difficulty making your payments, this will not affect your credit score because you will not report yourself to the major credit agency if things do not go as planned. - Capital is immediately available - No interest payments - No control procedures regarding creditworthiness - Spares credit line - No influence of third parties
Internal sources of financing, like cash drawn from a company's operating budget or capital income to fund a project or expansion, may be the simplest form of financing; this allows the company to make decisions quickly while avoiding the wait for financing approval and avoiding the cost of paying interest or dividends. However, this type of financing has important drawbacks that may mean that it is not always the best choice. Capital Needs
The chief concern with internal financing is that when you take money from your operating budget or capital, it leaves you with less money to manage daily expenses. In this way, using internal sources of financing for company endeavors can compete with budgets already in place. For this reason, internal investment is usually used to finance small projects and investments, where the costs are small, the payback quick, and the estimated returns significant. Knowledge Requirements
When a company evaluates whether to use internal financing for something, it has to be able to estimate with reasonable accuracy the true costs of the project and provide an accurate forecast for recoupment of the investment. It also has to determine whether the return is adequate enough to justify the type of investment; the acceptable minimum level of return is referred to as the "hurdle rate." The accuracy of these calculations depends on how well the company is able to estimate its costs, predict trends and manage the budget outlined. When a company applies for external financing such as a loan, these calculations and figures are scrutinized because the creditor would stand to lose if the company later found it could not repay the debt; internal financing lacks this secondary "audit." Tax Benefits
Further, there are other benefits of external financing that internal sources of financing don't have, such as the tax benefits of having external debt. The interest the company pays on external debt is tax deductible, as is the depreciation of any asset purchased. For this reason, the higher a company's tax rate, the more external financing or debt it is likely to have in its capital structure. Discipline
Moreover, internal financing is so easy that it leads to a lack of discipline. The company risks becoming inefficient or even complacent unless it strictly monitors the project's investment, budget and any increase in earnings that stems from the project. These actions would normally be required if the company took on debt, such as a loan, or used external financing like issuing stock. - Expensive because internal financing is not tax-deductible - No increase of capital - Not as flexible as external financing - 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)