2.1.1 internal finance

1. Retained Profit:

• Definition: Retained profit is the portion of net profit that a company decides to keep or "retain" instead of distributing it to shareholders as dividends.

• How it Works: At the end of the financial year, after all costs (including dividends) have been deducted from the revenue, the remaining profit can be retained within the business.

• Usage: Retained profit can be used for reinvestment into the business, such as funding new projects, expanding operations, or paying for capital expenditures (like machinery, equipment, etc.).

• Advantages:

  • No Interest or Repayment: Unlike external finance (e.g., loans), retained profit does not require repayment or interest payments.

  • Financial Independence: Retained profit provides financial flexibility without the need to involve external lenders or shareholders.

• Disadvantages:

  • Opportunity Cost: Using retained profit means shareholders might receive lower dividends, which could affect their satisfaction or the company’s stock price.

  • Limited Amount: The amount of retained profit depends on the business's profitability. A company with low profits might not have sufficient retained earnings for major investments.

2. Sale of Assets:

• Definition: This involves selling off business assets (such as property, equipment, or vehicles) to raise funds.

• How it Works: A business may decide to sell underused or non-essential assets to generate cash for immediate needs or investment.

• Examples:

  • Selling old machinery that is no longer needed.

  • Selling surplus office space or buildings.

• Advantages:

  • Quick Access to Cash: The sale of assets provides immediate cash flow for the business.

  • No Need for Repayment: Unlike loans, the sale of assets does not require the business to pay back anything over time.

• Disadvantages:

  • Loss of Assets: Selling assets may mean the business loses the ability to use them in the future, potentially affecting operations.

  • Depreciation: Assets sold might have depreciated in value, meaning the business could not recoup their full original investment.

3. Depreciation:

• Definition: Depreciation refers to the gradual reduction in the value of a fixed asset (e.g., machinery, buildings, vehicles) over time due to wear and tear or obsolescence.

• How it Works: While depreciation itself is not an actual cash inflow, businesses can account for depreciation as an expense. The business then saves this money as part of the retained profit, which can later be used for future investment.

• Examples:

  • A factory machine depreciates over 5 years. The company can factor this depreciation into its financial statements and set aside money for replacement or upgrades.

• Advantages:

  • Tax Benefits: Depreciation can reduce the taxable income of the business, lowering tax liabilities and generating cash flow.

  • Planning for Future Investments: Depreciation allows businesses to plan for the eventual replacement or upgrading of assets, maintaining operational efficiency.

• Disadvantages:

  • Non-Cash: Depreciation is a non-cash expense. Although it reduces profit for tax purposes, it doesn't directly generate funds.

4. Working Capital Management:

• Definition: Working capital refers to the difference between a business's current assets (e.g., cash, inventory, receivables) and current liabilities (e.g., payables, short-term debt).

• How it Works: A business can improve its internal finance by efficiently managing working capital. For example, it can reduce the amount of money tied up in stock, collect receivables faster, or extend payment terms with suppliers.

• Examples:

  • Reducing Inventory: By reducing excess stock, a business can release cash that was previously tied up in inventory.

  • Tightening Credit Terms: A business can collect outstanding payments from customers more quickly to improve cash flow.

• Advantages:

  • Improved Cash Flow: Proper working capital management ensures the business has enough liquidity to meet short-term obligations and invest in opportunities.

  • Flexibility: Good management of current assets and liabilities allows the business to operate smoothly without needing external financing.

• Disadvantages:

  • Risk of Shortages: Too tight control of working capital might lead to stockouts, delays in production, or dissatisfied customers.

  • Complexity: Efficient working capital management requires careful forecasting and attention to detail.

Advantages of Internal Finance:

1. No External Debt: The business does not have to rely on loans, which would accrue interest and require repayment.

2. No Loss of Ownership: Unlike equity financing, where the business might have to give up ownership or control, internal finance allows the business to retain full ownership.

3. Flexibility: The business has more control over how the funds are used without needing to comply with external lenders or shareholders.

4. Lower Financial Risk: Because there’s no debt involved, businesses using internal finance are less at risk of overleveraging.

Disadvantages of Internal Finance:

1. Limited Funds: The business is limited to the amount of internal finance available, which may restrict its ability to make large investments or fund significant expansion.

2. Opportunity Cost: Using retained profits means that money could have been distributed as dividends to shareholders, potentially affecting their satisfaction.

3. Slower Growth: Relying solely on internal finance may limit the speed of expansion, especially for businesses in capital-intensive industries that require large upfront investment.