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What is Internal Finance?

Mary McMahon
By
Updated May 16, 2024
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Internal finance is money that comes from within a company, rather than from external sources. Companies may use it for investments in lieu of arranging external financing. One advantage to using internal finance for investments is that the company does not incur transaction costs such as origination fees and interest, since the money comes from the inside. Company balance sheets provide information about the amount of money available through internal finance and other financial matters that reflect on a company's financial health.

There are several sources of internal finance. One is depreciation, a tactic that increases cash flow by allowing companies to write down the value of assets over time. Depreciation can be a very powerful accounting tool when it is applied correctly. As assets are depreciated, tax liability decreases, allowing the money to keep funds that it otherwise would have needed to use to pay taxes. This frees up capital for investments and other endeavors.

Retained earnings, also called surplus or undistributed profits, are another source of internal finance. Companies that make payments to shareholders can opt to retain money instead of paying it out to fund investments. This is beneficial for the company in the long term as it increases the possibility for future earnings. Undistributed profits, in other words, do eventually work their way into the hands of shareholders as the company invests that money and increases its profits.

Companies can also raise internal finance by selling off assets for cash. This can include real estate, patents, works of art, and other assets controlled by the company. Sale of assets must be done with care to avoid taking losses or exposing the company to the risk of future losses. Companies in need of cash in a hurry can end up in trouble, as they may be forced to sell assets below market value in order to get cash into company coffers.

When companies are considering new investments, they can weigh available sources of finance to determine which would be most appropriate for a new endeavor. Internal finance can be appealing for certain types of investments, while in other cases, there may be advantages to external financing. Companies that choose to finance through the outside can retain internal funds to cover the company in an emergency, for example. Board members vote on whether or not new investments should be pursued and the type of financing the company should use.

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Mary McMahon
By Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a SmartCapitalMind researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

Discussion Comments
By anon350997 — On Oct 09, 2013

Internal financing is good in case of medium and big businesses in a developing country like India where the expenses of external finance is a big amount like an international business loan. Internal financing can improve the performance step by step, but you should invest in the right place at the right time, and to the right extent. External finance is normally a big amount so there is scope for bigger development in the case of external finance, but again you should think about your need and how much you need.

By sehiggins — On Jun 21, 2011

In the case of my brother's company, using internal funds turned out horribly wrong.

He was in the business of shoe repair. He wrote off depreciation of equipment in his taxes to increase his cash flow. With this excess cash, he hired an assistant store manager. He thought having another person working with him would make handling day to day operations easier.

The guy he hired turned out to be a crook, and ending up stealing over $800 from him.

Although this is an extreme situation, I just wanted to share it to let people know that they should be careful how they spend their excess money.

By epiphany5 — On Jun 20, 2011

My company was recently going through some hard times. Our sales had been steadily decreasing, and we needed to sell off some of our assets, or risk having to lay off employees instead.

We had several warehouse facilities that we were not using to full capacity. We decided to sell them, and it was one of the greatest things that happened to our business.

With the money we made from selling some warehouse space, we were able to invest more into advertising campaigns. Afterwards, we saw in increase in sales.

Internal financing works wonders!

By SuperJD — On Jun 19, 2011

@Farah1 - I could not agree more with your post. Internal financing is very limiting. My business professors lectured time and time again that internal financing does not work for every company, and could only be used in special cases.

I also learned that another disadvantage of internal financing is the fact that losses associated with it cannot be written off in taxes. If for some reason the internal capital is lost, the government can't do anything to lessen the loss.

This might be a small risk to take though, especially if the investment made with the internal funds is not a risky one.

By Farah1 — On Jun 18, 2011

@drhs07 - You bring up a valid point. Internal financing can be a way for companies to keep matters to themselves. But in certain instances, a company might not have the means to use internal funding only.

I think that this is one of the disadvantages of internal financing. Funds are limited internally, as a company can only work with what they have if they are set on only operating with internal financing.

However, one of the advantages of external financing is the greater amount of resources and possibilities of capital. When a company does not have the money to fund their new project, then external financing is the only option.

By drhs07 — On Jun 16, 2011

In my undergraduate finance classes, we intensely studied the advantages and disadvantages of internal financing. I think that the advantages far outweigh the disadvantages, and companies should look to internal financing as a means of expanding their company.

One of the best reasons for internal financing is not having to deal with a third party outside of the company. You can avoid paying fees and interest if you use your own source of funding rather than taking a loan elsewhere.

If the opportunity is there, internal financing is the way to go when funding a new business venture.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a...

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