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.