Internal Sources of Finance

Internal sources of finance refer to means of raising finance within an organization. Internal sources are the most important and cost-effective way to raise funds for the company. The internal sources of finance involve raising funds from within the company to meet business expenditures. A new company cannot raise finance through internal sources but an existing company can raise finance through both internal and external sources.

Internal sources of finance can be classified into three categories-

• Owners Capital
• Depreciation funds
• Retained earnings

Owners Capital

It refers to the amount of funds invested by the owner of the business. The owner may choose to use his/her personal savings to meet the business expenditures.

Depreciation Fund

Depreciation funds are an important source of internal finance.

Depreciation means a decrease in the value of assets due to wear and tear, obsolescence, accident, etc. generally depreciation is charged against fixed assets of a company at a fixed rate every year.

A depreciation fund is created to meet the working capital requirements of the business and account for depreciation on the company’s assets. It is one kind of provision of the fund, which helps to reduce the tax burden and increase the overall profitability of the company.

Retained Earnings

It represents the earnings not distributed to shareholders. A firm may retain a portion or whole of its profits and utilize it for financing its projects.

Retained earnings are another method of internal sources of finance. Under this, a particular part of the company’s profit are reserved as retained earnings for meeting its short-term financial needs. According to the companies act 1956 certain percentage, as prescribed by the central government (not exceeding 10%) of the net profit after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring its dividends.

• Retained earnings are useful for the expansion and diversification of the company.
• A company does not need to raise loans for further requirements if they have retained earnings.
• Retained earnings are one of the cheapest sources of finance.
• Sometimes excessive use of retained earnings leads to a monopolistic attitude of the company.
• The management by manipulating the value of the share in the stock can misuse the retained earnings.