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IB DP Business Management Study Notes

3.1.1 Internal Sources

Internal sources of finance refer to the methods a business can utilise to generate funds from within its operations and existing structures, without relying on external sources. For businesses, leveraging internal finance sources is a way to harness growth without accruing new debts or obligations to external stakeholders. Two prominent internal sources of finance are retained earnings and the sale of assets. Understanding these sources is essential, particularly when contrasting them with external sources of finance.

Retained Earnings

Retained earnings refer to the net income that a business has decided to keep, rather than distribute among its shareholders in the form of dividends. This decision impacts the internal vs external stakeholders, who may have differing interests regarding the use of these funds.

Characteristics of Retained Earnings:

  • Accumulative: They accumulate over the years as profits are continually reinvested in the business.
  • Equity Finance: Retained earnings increase the equity of the shareholders as they represent the shareholders' claim on the company's assets, which is reflected in the components of the balance sheet.

Advantages:

  • No Interest Obligation: Since it's not borrowed money, there’s no need to pay any interest.
  • No Dilution of Ownership: Unlike issuing additional shares, using retained earnings doesn’t dilute the ownership of existing shareholders.
  • Flexibility: Retained earnings can be utilised as per the company’s discretion without many external constraints.

Limitations:

  • Opportunity Cost: Shareholders forgo potential dividends and may require a higher future return due to this opportunity cost.
  • Overcapitalisation: Over-reliance on retained earnings without efficient reinvestment strategies can lead to overcapitalisation. Efficient reinvestment can be measured through financial tools like Net Present Value (NPV).

Sale of Assets

The sale of assets involves disposing of tangible or intangible assets owned by the business in exchange for cash or other considerations. This can include property, equipment, patents, or other business resources. Decisions to sell assets can be a strategic move to manage long-term financing needs.

Characteristics of Sale of Assets:

  • One-off Source: It's a non-recurring source of finance, unlike retained earnings that can be accumulated over time.
  • Direct Infusion of Cash: The sale of assets usually results in an immediate boost to liquidity.

Advantages:

  • Immediate Liquidity: Helps in obtaining quick cash for immediate financial needs.
  • No Interest or Debt: Assets are sold, not borrowed against, so there's no interest or repayment schedule.
  • Efficient Resource Utilisation: Disposing of underutilised or obsolete assets can be more efficient than letting them depreciate.

Limitations:

  • Loss of Future Benefits: Selling an asset might mean giving up future revenue that the asset could have generated.
  • Possible Tax Implications: The sale could lead to capital gains tax if sold at a profit.
  • Dependence on Market Conditions: The amount generated from the sale highly depends on the current market conditions.

FAQ

Yes, there are scenarios where selling assets might not be in the best interest of a business. If the asset sold is core to the company's operations, it might jeopardise the company's future earning potential. For instance, a restaurant selling its kitchen equipment to meet short-term liquidity needs might find it difficult to operate efficiently in the future. Furthermore, if assets are sold during economic downturns or periods of market depression, the business might not get the best value for them. Also, frequent selling of assets might signal financial instability to stakeholders, potentially damaging the company's reputation and trustworthiness in the market.

While retained earnings represent accumulated profits not distributed as dividends, their utilisation can sometimes be restricted. Legal or contractual stipulations might prevent companies from using them freely. For instance, some debt agreements might contain covenants that require companies to maintain a certain level of equity. Also, if a company anticipates future financial needs or foresees potential financial challenges, it might voluntarily set aside a portion of retained earnings as a reserve, restricting its immediate use. Furthermore, regulatory bodies might impose restrictions to ensure financial stability in specific sectors, especially in industries like banking.

Selling intangible assets, like patents, trademarks, or copyrights, can be more complex than selling tangible assets. Firstly, valuing intangible assets can be challenging due to their lack of physical presence and their valuation often depends on factors like future revenue potential, market conditions, or competitive landscape. Secondly, the sale of intangible assets might have wider implications. For instance, selling a patent might mean giving competitors access to a unique technology. In terms of internal financing, while both can provide immediate liquidity, the sale of intangible assets might bring in larger sums if they have significant value or potential, but they might also involve more extended negotiations and due diligence processes.

Retained earnings and reserve funds are both parts of a company's equity, but they serve different purposes. Retained earnings refer to the accumulated profits that a company has chosen not to distribute as dividends. They represent the net income of a company over time, after accounting for dividends. On the other hand, a reserve fund is an amount set aside from profits for a specific purpose, such as future expansion, offsetting future losses, or replacing assets. While retained earnings showcase a company's ability to generate profits, reserve funds highlight a company's financial prudence and preparedness for future uncertainties.

A company might prefer retained earnings over external financing for several reasons. Firstly, retained earnings are essentially the company's own funds, meaning they come without the attached interest costs of loans. This makes them cost-effective. Secondly, using retained earnings avoids the potential restrictions and covenants that lenders often impose. This ensures the company maintains its operational freedom. Additionally, leveraging retained earnings can enhance shareholder confidence as it signals the company's capability to finance its operations and growth from its own generated profits, without resorting to external borrowings. Lastly, using internal funds reduces the overall financial risk of the business.

Practice Questions

Explain the advantages and limitations of retained earnings as an internal source of finance.

Retained earnings, as an internal source of finance, offer several advantages. Firstly, they do not carry an interest obligation, providing financial relief compared to borrowed funds. Secondly, utilising retained earnings prevents dilution of ownership, ensuring the existing shareholders' control remains intact. Furthermore, they offer a degree of flexibility, allowing the company to allocate funds as per its discretion. However, there are also limitations. Using retained earnings introduces an opportunity cost as shareholders forgo potential dividends, possibly requiring higher future returns. Additionally, an over-reliance without efficient reinvestment can lead to overcapitalisation, where more capital is invested in the business than is needed, leading to inefficiencies.

Discuss the implications of selling assets as an internal financing method.

Selling assets as an internal financing method can provide immediate liquidity to a business, especially useful in times of financial distress or when needing to raise funds quickly. It's a direct method that doesn't entail interest or further debt. Moreover, it promotes efficient resource utilisation by letting businesses dispose of underutilised or obsolete assets. However, this method also comes with its set of implications. By selling assets, businesses might lose out on future revenue that these assets could have potentially generated. Additionally, there could be tax implications, particularly if assets are sold at a profit, leading to capital gains tax. Furthermore, the amount generated is highly dependent on prevailing market conditions, which might not always be favourable.

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