B Com Exam > B Com Notes > Accountancy and Financial Management > Internal Finance - Sources of Finance, Accountancy and Financial Management
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Internal Finance
A company can mobilize finance through external and internal sources. A new company may not raise internal sources of finance and they can raise finance only external sources such as shares, debentures and loans but an existing company can raise both internal and external sources of finance for their financial requirements. Internal finance is also one of the important sources of finance and it consists of cost of capital while compared to other sources of finance.
Internal source of finance may be broadly classified into two categories:
A. Depreciation Funds
B. Retained earnings
Depreciation Funds
Depreciation funds are the major part of internal sources of finance, which is used to meet the working capital requirements of the business concern. Depreciation means decrease in the value of asset due to wear and tear, lapse of time, obsolescence, exhaustion and accident. Generally depreciation is changed against fixed assets of the company at fixed rate for every year. The purpose of depreciation is replacement of the assets after the expired period. It is one kind of provision of fund, which is needed to reduce the tax burden and overall profitability of the company.
Retained Earnings
Retained earnings are another method of internal sources of finance. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities. Retained earnings are called under different names such as; self finance, inter finance, and plugging back of profits. According to the Companies Act 1956 certain percentage, as prescribed by the central government (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year. Under the retained earnings sources of finance, a part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
Advantages of Retained Earnings
Retained earnings consist of the following important advantages:
- Useful for expansion and diversification: Retained earnings are most useful to expansion and diversification of the business activities.
- Economical sources of finance: Retained earnings are one of the least costly sources of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different types of securities.
- No fixed obligation: If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest.
- Flexible sources: Retained earnings allow the financial structure to remain completely flexible. The company need not raise loans for further requirements, if it has retained earnings.
- Increase the share value: When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance; Hence the value of the share will increase.
- Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.
- Increase earning capacity: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:
- Misuses: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.
- Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.
- Over capitalization: Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance.
- Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.
- Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.
Difference Between Internal and External Sources of Finance
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FAQs on Internal Finance - Sources of Finance, Accountancy and Financial Management - Accountancy and Financial Management - B Com
| 1. What are the main sources of internal finance? |  |
Ans. Internal finance refers to the funds generated from within an organization. The main sources of internal finance include:
- Retained earnings: These are the profits that a company reinvests into the business instead of distributing them to shareholders as dividends.
- Depreciation: It is a non-cash expense that represents the decrease in value of assets over time. Companies can use depreciation to generate internal funds.
- Working capital management: Efficient management of working capital, including managing inventory, receivables, and payables, can free up cash within the business.
- Sale of assets: Companies can generate internal finance by selling off assets that are no longer needed or are underutilized.
- Cost control measures: Implementing cost-saving measures and improving operational efficiency can generate internal finance by reducing expenses.
| 2. What is the role of accountancy in managing internal finance? | |
Ans. Accountancy plays a crucial role in managing internal finance. It involves the recording, analyzing, and reporting of financial transactions within an organization. Some key roles of accountancy in managing internal finance include:
- Financial record-keeping: Accountants maintain accurate and reliable financial records, which are essential for monitoring internal finance.
- Financial analysis: Accountants analyze financial data to assess the financial health of the organization and identify areas for improvement in managing internal finance.
- Budgeting and forecasting: Accountants prepare budgets and financial forecasts, which help in planning and allocating internal finance effectively.
- Internal control systems: Accountants design and implement internal control systems to safeguard assets, prevent fraud, and ensure the proper utilization of internal finance.
- Financial reporting: Accountants prepare financial statements and reports that provide insights into the organization's internal finance to stakeholders and management.
| 3. What is financial management and why is it important for internal finance? | |
Ans. Financial management involves the planning, organizing, directing, and controlling of an organization's financial resources. It is important for internal finance as it ensures the efficient utilization of funds and maximizes the value of the organization. Some key reasons why financial management is important for internal finance are:
- Optimum fund allocation: Financial management helps in identifying the best utilization of internal finance by prioritizing investment opportunities, managing working capital, and optimizing capital structure.
- Risk management: Financial management involves assessing and managing financial risks, such as liquidity risk, credit risk, and market risk, which can impact internal finance.
- Decision-making support: Financial management provides relevant financial information and analysis to support decision-making related to internal finance, such as investment decisions, financing decisions, and dividend decisions.
- Performance evaluation: Financial management helps in evaluating the performance of the organization by analyzing financial ratios, profitability measures, and other financial indicators related to internal finance.
- Long-term sustainability: Effective financial management ensures the long-term sustainability of the organization by maintaining a healthy cash flow, managing debt, and achieving financial stability.
| 4. How can businesses improve their internal finance management? | |
Ans. Businesses can improve their internal finance management by implementing the following strategies:
- Efficient working capital management: By optimizing inventory levels, improving collection of receivables, and extending payables, businesses can enhance their internal finance.
- Cost control measures: Reducing unnecessary expenses, negotiating better deals with suppliers, and implementing cost-saving initiatives can free up internal finance.
- Cash flow forecasting: Regularly forecasting cash flow helps businesses to anticipate any cash shortages or surpluses, enabling effective internal finance management.
- Investment in technology: Adopting financial management software and tools can streamline financial processes, improve accuracy, and enhance internal finance management.
- Financial analysis and monitoring: Regularly analyzing financial statements, conducting variance analysis, and monitoring key financial indicators help businesses to identify potential issues and take corrective actions for better internal finance management.
| 5. How does internal finance impact the overall financial health of an organization? | |
Ans. Internal finance has a significant impact on the overall financial health of an organization. Some key impacts of internal finance include:
- Financial stability: Effective internal finance management ensures a stable cash flow, which is essential for meeting operational expenses, debt obligations, and investment requirements.
- Growth and expansion: Adequate internal finance enables businesses to fund their growth initiatives, such as expanding into new markets, investing in research and development, or acquiring new assets.
- Profitability and shareholder value: Internal finance plays a crucial role in generating profits and increasing shareholder value by supporting strategic investment decisions and maximizing operational efficiency.
- Risk management: Well-managed internal finance helps in mitigating financial risks, such as liquidity risk and solvency risk, which can impact the overall financial health of the organization.
- Financial flexibility: Internal finance provides the organization with flexibility in managing its financial resources, allowing it to respond to market changes, economic uncertainties, and growth opportunities effectively.
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