When a firm looks to raise capital to finance a project, it has two options, to seek internal financing or to find external financing. External funds are provided by banks, venture capitalists and other investors. Internal financing comes from the sources within the business that are easily accessible. It is simple and easy and saves a lot of effort that would have otherwise gone into raising capital from external sources.
Internal financing is the preferred means of raising money for firms that want to remain debt-free or are unwilling to pay heavy interest rates on the raised capital.
There are a number of sources for internal financing of a project. Here’s a look at them.
This is the most important source of internal financing. Retained earnings exist because of profit, i.e. one exists because of the other. If a company generates no profit, then it won’t be able to transfer anything to its retained earnings.
Without profits, a business cannot think of financing its projects via internal sources. For instance, if a firm is not generating any profits but wishes to invest in a project, should it consider selling its assets? Here, the better option would be to choose an external source of financing.
Retained earnings is generally a portion of the profit or all of it, which is set aside for reinvesting in the company.
Businesses can consider selling off their non-current assets, such as old machinery, inventory, and properties, to fund any immediate requirement for money. If a business chooses to sell its useful or working assets, it is unlikely to reap any benefits from such assets and would disturb the balance of operations. A firm can also use a sell and lease back strategy, where the company can raise cash by selling assets, but then use those assets on lease for the smooth functioning of the firm.
This is the least used source of internal financing but can be used if a firm needs a small amount of immediate cash. Speeding up the cycle of accounts receivables will provide cash quickly. Lengthening this process will keep the cash for a period of time in the company. This money can then be utilised by the firm.
Apart from these sources, employee contribution and personal savings can also be used for internal financing.
The more a firm depends on external sources of financing, the more it is likely to be at risk of losing ownership rights. If you fund a project or expansion with the help of venture capital, the investors would want an ownership stake and voting rights, instead of just settling for profits. If you take a loan backed by your assets, the lender will own your assets if you default on the debt. If the lender agrees not to seize the assets of your firm, they might demand ownership in return. The more shares you issue to raise capital, the less will be your ownership stake. Internal financing prevents a firm from sharing or selling its ownership rights.
Depending on the type of external financing, you might have to give some form of control of your firm when you opt for external sources of funding. You may have to provide voting rights or a seat on the board, which might reduce your decision-making powers. Banks might degrade your credit ratings, in the event of loan default and would demand bringing in a consultant for further credit approval. Internal financing prevents you from sharing control and rights of your firm to external entities.
External financing mainly involves payment of some form of interest or dividend, increasing the overhead costs and lowering the levels of profit. Internal financing prevents you from paying dividends or high rates of interest.
A company with low debt is more attractive to potential investors. Low external debt improves the credit rating of your firm too and offers a number of options for raising capital in the future. You may consider depreciating equipment to fund operations. This will reduce your tax obligations and will show potential investors a lower rate of tax.
The main problem with internal financing is that when you allocate money from your operational capital, it leaves the firm with less money to operate efficiently on a daily basis. Internal financing for new projects can distort the overall budget of a firm. Due to this, small investments and projects, with low capital requirements and offering swift returns on investment, are preferred for internal financing.
Evaluation of the true costs of the project and return on investment should be accurate when a firm decides to use internal financing. This evaluation also needs to prove that the returns justify this investment. Precision of this calculation depends on how well the firm is able to predict costs, trends and manage the set outline of the budget. When a company applies for any source of external financing, these calculations and figures are closely inspected by creditors to avoid bad loans and to evaluate the feasibility of the project. Internal financing usually lacks secondary auditing, so auditing by a third party can be considered.
External financing provides tax benefits that internal financing doesn’t. The interest paid by a firm on an external debt is tax deductible, as is the depreciation of any asset purchased from external debt. This is why bigger companies tend to have higher levels of debt or external financing in their capital structure. Internal financing offers no such tax deductions.
Internal financing may lead to a lack in discipline, since there is no obligation on the management to utilise the capital to its utmost potential. A firm can become inefficient and even self-satisfied unless the investment, budget and the increase in revenue generated from a project are strictly monitored. This monitoring is generally required in case a company takes a loan or uses any external source of financing.
Internal financing is a good option for quick access to cash and freedom, but has some limitations attached to it. A company may consider external sources first before looking at internal sources of finance.