Internal Sources of Finance

Internal Sources of Finance

Internal sources of finance refer to funds generated within a company through its own operations, without relying on external sources such as loans or equity investments. These sources provide flexibility and autonomy to businesses while leveraging their own resources for growth and expansion. In this chapter, we will explore three key internal sources of finance: reserves and surplus, bonus shares, and retained earnings.

1. Reserves and Surplus:

   - Reserves and surplus represent accumulated profits retained by a company over time.

  - These funds are set aside from the company's profits after meeting all expenses, taxes, and dividends.

   - Reserves and surplus are typically categorized into various types, including:

   - General Reserves: Created to strengthen the financial position of the company and provide a cushion against unforeseen losses.

     - Capital Reserves: Generated from capital transactions such as the sale of fixed assets or revaluation of assets and are not available for distribution as dividends.

     - Revenue Reserves: Accumulated from revenue-generating activities and may be used for various purposes, including expansion, investment, or dividend payments.

Advantages of Reserves and Surplus:

     - Provides a stable source of internal funding for business operations and expansion.

     - Enhances the company's financial stability and resilience by building a financial cushion against future uncertainties.

     - Enables the company to pursue growth opportunities, invest in new projects, or undertake research and development initiatives.

Limitations of Reserves and Surplus:

     - Over-reliance on reserves and surplus for financing may result in underutilization of funds and missed investment opportunities.

     - Accumulating excessive reserves may signal to investors that the company lacks growth prospects or is not utilizing its resources efficiently.

2. Bonus Shares:

   - Bonus shares are additional shares issued by a company to its existing shareholders without any cash payment.

   - These shares are issued as a form of capitalization of company reserves or surplus.

   - Bonus shares are distributed to shareholders in proportion to their existing shareholdings.

   - The primary purpose of issuing bonus shares is to capitalize the company's profits and strengthen its equity base without diluting ownership.

Advantages of Bonus Shares:

     - Enhances shareholder value by increasing the number of shares held by existing shareholders without requiring additional investment.

     - Improves liquidity in the market by increasing the number of tradable shares, which may attract more investors.

     - Signals confidence in the company's financial strength and future prospects, leading to a positive perception among investors and stakeholders.

Limitations of Bonus Shares:

     - Does not provide immediate cash inflow to the company, which may limit its ability to finance short-term obligations or investment opportunities.

     - Dilutes earnings per share (EPS) and may lead to a decline in the market price per share in the short term, especially if investors perceive the bonus issue as a signal of overvaluation or lack of investment opportunities.

3. Retained Earnings:

   - Retained earnings are the portion of profits that a company retains and reinvests in its business rather than distributing them as dividends.

   - These earnings accumulate over time and are reflected in the company's balance sheet under shareholders' equity.

   - Retained earnings can be used for various purposes, including financing growth initiatives, debt reduction, dividend payments, or share buybacks.

Advantages of Retained Earnings:

     - Provides a stable and reliable source of internal funding for business expansion, research and development, and capital investments.

     - Allows the company to maintain financial flexibility and independence without relying on external financing or debt.

     - Enhances shareholder wealth in the long term by supporting sustainable growth and increasing the company's intrinsic value.

Limitations of Retained Earnings:

     - Limited availability of retained earnings may constrain the company's ability to fund large-scale expansion projects or acquisitions.

     - Retaining excessive earnings without distributing dividends may lead to dissatisfaction among shareholders seeking regular income or dividend payments.

     - Inefficient allocation of retained earnings towards low-return projects or investments may result in suboptimal utilization of resources and reduced shareholder value.

Conclusion:

Internal sources of finance, including reserves and surplus, bonus shares, and retained earnings, play a crucial role in enabling companies to fund their growth and expansion initiatives. By leveraging their own resources, companies can enhance financial stability, support long-term value creation, and maintain autonomy in decision-making. However, it is essential for companies to strike a balance between retaining earnings for reinvestment and distributing profits to shareholders to ensure sustainable growth and shareholder satisfaction.