Internal sources of finance are generated internally by the business-like retained earnings, sale of assets, debt collection, and discounted selling.
Internal sources of finance are easily accessible, simple, and save a lot of effort. Internal financing is the preferred means of raising finance for companies that want to remain debt-free.
1) Retained Earnings
Retained earnings are the most important internal source of finance. The funds of retained earnings can be used to reward shareholders in the form of dividend payment or share buybacks and used to invest in projects and grow the business.
The advantage of using retained earnings as an internal source of finance is already the company’s own money so the company doesn’t have to worry about debt obligations.
The advantage of retained earnings is that it is a very flexible means of finance, and the company does not have to worry about defaults in repayments.
But the problem in using retained earnings is that the shareholders will get fewer dividends. When dividends are low, shareholders will lose their opportunity income.
2) Sale of Assets
The sale of assets is another form of an internal source of finance. When a business sells off its assets uses the cash internally for financing capital needs it is called the sale of assets. If a business has unused equipment, working capital can be raised by selling that equipment.
The sale of assets can be short-term or long-term depending on the type of assets. It can be a good way to check the fixed asset register regularly to find out which assets are obsolete and sell those assets to raise finance.
But there is a drawback that there is a possibility of loss in the form of capital loss due to the asset being sold at scrap value.
3) Reducing Working Capital
Reducing working capital can be another interesting internal source of finance. Reducing working capital is managing available money more closely.
If a business can negotiate shorter billing times with its clients and longer payment terms with its suppliers, it will receive funds faster and pay bills more slowly. This approach will require a good relationship with these stakeholders.
The advantage of reducing working capital is savings on the interest cost paid on working capital loans, bank overdrafts, cash credit, etc. But there is a risk of bankruptcy in the method of working capital reduction.
4) Debt Collection
Sometimes businesses allow their customers more flexible credit terms which are certainly a bad practice on several grounds. Businesses should focus and develop appropriate policies and strategies on the timely collection of debts.
If a business has customers who do not pay on time, then collecting these debts is important to reduce the cash cycle and use those cash as an internal source of finance.
In order to collect the debt from customers, businesses can adopt an invoice factoring policy which is a specialist finance policy that pays 80% of the invoice value and collects the invoice for the business.
When the customer pays, the company gets the balance of the invoice less the factoring company’s fees. Invoice factoring is not a long-term solution, but for businesses with temporary cash flow problems, it can be a helpful method of raising money.
5) Discounted Selling
Companies can raise finance by selling unsold inventory at a discounted selling price. A company can sell a surplus of last season’s fashions at a reduced price to raise cash or can sell unused machinery or vehicles no longer needed.
6) Delay Payment to Suppliers
By delaying payment to the supplier funds can be retained in the business and these funds can be used for another purpose or during crisis moments.
While delaying payments to suppliers it is important to consider that costs will incur if the payment period is extended beyond the agreed limit with the supplier and the business reputation could be damaged also.
If a good relationship with the supplier is maintained it may be possible to establish an agreement with them to extend the credit period during times of crisis and this way the risk of additional cost and loss of reputation can be avoided.
7) Reduce Stock Level
Large amounts of funds are used in holding large amounts of stock which prevents businesses from spending in other areas. If the inventory is decreased to an adequate level so that future sales orders will be satisfied it will be possible to use the fund for profitable activities. It must be ensured that a sufficient stock level is built to meet anticipated future sales demand. Reducing inventory level