Source of finance | Internal funds | Depreciation | Surplus funds

Internal funds as source of finance

Internal finance is also known as self financing by a company. Internal finance includes the funds generated within the corporate unit irrespective of the nature of source.

In other words the extent of profitability after tax, the size of dividend payments and the amount of depreciation provided for along with the reserves and surplus all contribute to the sources of internal funds and these funds can be used by a company financing the cost for acquisition of fixed assets, expansion modernization or diversification, etc.

There exists a controversy whether depreciation should be taken as a source of finance. Whatever may be the outcome of such controversy, the fact remains that the depreciation is a sum that is set apart out of profits and retained within the business and finance the capital needs in the normal business routine, and as such depreciation in true academic sense be deemed as a source of internal finance.

Sources of Total Finance:

  • Paid up Capital – Equity and Preference
  • Reserves and Surplus – Including Share Premium
  • Secured Loans
  • Unsecured Loans
  • Current Liabilities and Provisions
  • Depreciation Provision

Sources of Internal Finance:

  • Bonus issue and shares paid-up
  • Bonus issue of preference shares
  • Reserves and Surpluses
  • Provision including provisions for depreciation

Depreciation as source of finance

Amongst all the sources of internal finance, main source is depreciation on an average as revealed by some research studies done by research scholars. The second source is reserves and surplus and lastly the bonus issue of preference shares or equity shares.

As regards depreciation, the term denotes the funds set apart for replacement of worn-out assets. Depreciation is a deduction out of profits of the company calculated as per accounting rules on the basis of estimated life of each assets each year to total over the life of the assets to an amount equal to to original value of the assets.

Although depreciation is meant for replacement of particular assets but generally it creates a pool of funds which are available with a company to finance its working capital requirements and sometimes for acquisition of new assets including replacement of worn-out plant and machinery.

Depreciation is an expenditure recorded in the accounting system of a company and is allowed to be deducted while arriving at the net profits of the company subject to adherence of the percentages of allowable depreciation fixed under the tax laws.

Surplus funds as source of finance

Surplus are total sum of the left overs from various accounts in the accounting system of a company i.e. the “surplus” is the remaining part of the net income after distribution of dividends to the shareholders. A company is required to transfer 10% of the profit to reserves while declaring dividend which could be more depending upon the profitability of the company.

A company can distribute dividend out of the surplus but according to the rules as prescribed from time to time by the Government. Surplus is accumulated from other sources besides the remainder of earned income which are known as capital surplus and surplus arising from revaluation of assets. The entire surplus belongs to the equity holder as part of the net worth.

The main source of surplus remain the net profits from operations at a close of accounting period, past accumulated profits, conversion of unnecessary reserves, and non operating income. Surplus remain an important source of capital for both newly promoted companies and established companies. Surplus adds to the credit standing of newly promoted company to establish a market price for its equity shares. For an established company it becomes source of finance for comparison / diversification motivated schemes.

Surplus also supplement the reserves. Reserve, surplus and provisions, both form good sources of financing internally the development programmes within the company without much depending upon outside funds through borrowing. They meet the fixed and working capital requirements within the industry. Internal financing through utilization of company’s own funds is also known as ploughing back of profits.

Besides, internal funds help the company in number of ways viz

1. Achieve a suitable dividend policy and enlisting the support of the public;

2. help internal finance of projects without resumption of borrowings;

3. deficiencies in liability and reserves are fulfilled out of the retained income;

4. it is used for retiring bond or debentures for building up sinking funds for redemption of debt.

Thus, reserves and surplus add to the capital formation at micro level. The main determinants of internal funds are corporate earnings, taxation and corporate savings, and the dividends policy of the company.