Internal Finance Definition

Internal Finance Definition – Best Finance

Internal Finance

A corporation will mobilize finance through external and internal sources. a brand new company might not raise internal sources of finance and they can raise finance only from external sources such as shares, debentures, and loans but an existing company can raise each internal and external source of finance for his or her monetary necessities. Internal finance is also one of the important sources of finance and it consists of the cost of capital compared to other sources of finance.

Internal supply of finance could also be loosely classified into 2 categories:

  1. Depreciation Funds
  2. Retained earnings

Internal Finance

Depreciation Funds

Depreciation funds area unit the most important a part of internal sources of finance, that is employed to fulfill the capital necessities of the business. Depreciation means a decrease in the value of an asset due to wear and tear, the lapse of time, obsolescence, exhaustion, and accident. Generally, depreciation is changed against fixed assets of the company at a fixed rate every year. The purpose of depreciation is the replacement of the assets after the expired period. It is one kind of provision of the fund, which is needed to reduce the tax burden and overall profitability of the company. Internal Finance

Retained Earnings

Retained earnings area unit is another methodology of internal sources of finance. Actually is not a method of raising finance, but it is called an accumulation of profits by a company for its expansion and diversification activities. Internal Finance

Retained earnings are called under different names such as; self-financed, inter finance, and plugging back of profits.   According to the Companies Act 1956 a certain percentage, as prescribed by the central government (not exceeding 10%) of the net profits after tax of a financial year have to be mandatorily transferred to order by a corporation before declaring dividends for the year. Internal Finance

Under the maintained earnings sources of finance, a district of the full profits is transferred to varied reserves like general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc. Internal Finance

Advantages of Retained Earnings

Retained earnings contain the subsequent necessary advantages:

  1. Useful for expansion and diversification: Maintained earnings area unit most helpful to enlargement and diversification of the business activities.
  2. Economical sources of finance: Maintained earnings area unit one amongst the smallest amount of expensive sources of finance since it doesn’t involve any floatation value as within the case of raising funds by provision differing types of securities.
  3. No fixed obligation:  If the companies use equity finance they have to pay a dividend and if the companies use debt finance, they have to pay interest. But if the corporate uses maintained earnings as sources of finance, they have not to pay any fastened obligation relating to the payment of dividends or interest.
  4. Flexible sources: Maintained earnings permit the monetary structure to stay utterly versatile. The corporate needn’t raise loans for more necessities if it’s maintained earnings.
  5. Increase the share value: Once the corporate use, the maintained earnings because of the sources of finance for his or her monetary necessities, the price of capital is incredibly cheaper than the opposite sources of finance; thus the worth of the share can increase.
  6. Avoid excessive tax:  Retained earnings provide opportunities for evasion of excessive tax in a company when it has a small number of shareholders.
  7. Increase earning capacity: Retained earnings consist of the least cost of capital and also it is most suitable for those companies which go for diversification and expansion.

Disadvantages of Retained Earnings

Retained earnings also have certain disadvantages:

  1. Misuses: The management by manipulating the value of the shares in the stock the market can misuse the retained earnings.
  2. Leads to monopolies: Excessive use of retained earnings leads to a monopolistic attitude of the company.
  3. Over capitalization: Retained earnings lead to overcapitalization because if the company uses more and more retained earnings, it leads to an insufficient source of finance.
  4. Tax evasion: Maintained earnings cause nonpayment. Since the corporate reduces the tax burden through the maintained earnings.
  5. Dissatisfaction: If the corporate uses maintained earnings as sources of finance, the shareowner can’t get additional dividends. So, the shareowner doesn’t wish to use the maintained earnings as a supply of finance all told things. Internal Finance
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