Funding Sources: Types, Classification, and Self-Financing

Understanding Business Funding Sources

Securing financing is crucial for businesses to obtain the financial resources needed to manage expenses. A budget serves as a plan for allocating numeric resources to specific activities.

Key Considerations When Choosing a Funding Source

To select the most appropriate funding source, consider the following:

  • Interrelationship between Investment and Financing: Maintain a correlation that preserves the company’s financial equilibrium.
  • Cost of Funding: Every funding source has associated costs.
  • Consequences for Owners: The type of financing affects the benefits shared among the company owners, especially when using external funds.

Classification of Funding

Funding can be classified as follows:

  • Self-Financing: Resources belonging to the company owners.
  • External Funding: Funds from external sources.
  • Internal Financing: Funds generated by business activity.
  • Permanent Resources: Resources that make up the fixed passive.
  • Short-Term Resources: Resources that comprise short-term liabilities.

Self-Financing Explained

Self-financing, or internal financing, consists of funds generated by the company and allocated to expansion or maintenance of its activities. During a financial period, the company generates cash from two primary sources:

  • Profits obtained during the exercise.
  • Amortization expenses incurred (depreciation), which do not require immediate payment.

Depreciation represents the wear and tear valuation of physical capital.

Cash Flow = Result of the Year + Depreciation

Undistributed Profit = Profit for the Year – Dividends – Allocations to Reserves

Self-Enrichment

Self-enrichment consists of gains that have not been distributed among the company’s partners, aimed at enlarging the company’s overall profits. These are known as reserves, and there are several types:

  • Legal Reserve: Company Law stipulates that companies must allocate 10% of their profits to a legal reserve until it reaches 20% of their share capital.
  • Statutory Reserve: Established by the company’s own statutes.
  • Voluntary Reserve: Delivery is made by the company.
  • Premium Reserve: Occurs when shares are issued for a price higher than their nominal value.
Advantages and Disadvantages of Self-Financing

Advantages:

  • Greater autonomy and stability as the company does not depend on external resources and has no explicit cost.
  • Positive tax effect, as maintaining self-financing reduces profit and therefore tax savings.
  • Essential for small and medium-sized companies that face difficulties in obtaining external financing.
  • Stimulates investment as part of the profits will go to consumers while those not share invested in the company.

Disadvantages:

  • The absence of an explicit price for self-financing resources can lead to unprofitable investments if the opportunity cost is not adequately considered.
  • In companies like SAs, a disconnect between management and property can lead to overuse of self-financing.
  • Very few self dividends will be distributed among shareholders which will be affected to.
  • If few dividends are allocated, the stock prices of companies in the secondary market may decrease.