Internal finance is money from a company, not external sources, used for investments to avoid transaction costs. Sources include depreciation, retained earnings, and selling assets. Companies weigh funding sources to determine which is most appropriate for new investments.
Internal finance is money that comes from a company and not from external sources. Companies can use it for investments instead of arranging external financing. An advantage of using internal financing for investments is that the company does not incur transaction costs, such as commissions and interest, since the money comes from within. Company balance sheets provide information about the amount of money available through internal finance and other financial matters that reflect on the financial health of a company.
There are several sources of internal financing. One is depreciation, a tactic that increases cash flow by allowing companies to write down the value of assets over time. Depreciation can be a very powerful accounting tool when applied correctly. As assets depreciate, the tax liability decreases, allowing money to preserve funds that you otherwise would have needed to use to pay taxes. This frees up capital for investments and other endeavors.
Retained earnings, also called surplus or retained earnings, are another source of internal financing. Companies that make payments to shareholders may choose to hold the money instead of paying it out to finance investments. This is beneficial to the company in the long run, as it increases the possibility of future profits. Retained earnings, in other words, eventually find their way into the hands of shareholders as the company invests that money and grows its profits.
Companies can also obtain internal financing by selling assets for cash. This may include real estate, patents, works of art, and other assets controlled by the company. The sale of assets must be done carefully to avoid taking losses or exposing the company to the risk of future losses. Companies that need cash quickly can end up in trouble, as they may be forced to sell assets below market value to get cash into company coffers.
When companies are considering new investments, they can weigh the available funding sources to determine which would be most appropriate for a new endeavor. Internal financing may be attractive for certain types of investments, while in other cases, there may be advantages to external financing. Companies that choose to finance abroad can retain internal funds to cover the company in an emergency, for example. Board members vote on whether or not to seek new investment and the type of financing the company should use.
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