Internal Financing: Self-Financing and Its Implications

Posted on Mar 20, 2025 in Economy

Internal Financing or Cash Flow

Internal financing refers to the application of financial resources generated within the company itself, without resorting to external funding. Self-financing originates from the company’s profits and is intended for expansion or maintenance of its activities.

Classes of Self-Financing: Maintenance and Enrichment

Maintenance: Consists of retained profits aimed at preserving the company’s economic strength. It is formed through:

  • Amortization of tangible and intangible assets.
  • Provisions on current and non-current assets.

Depreciation is charged against the profit of each financial year, reflecting the depreciation of non-current assets. These are costs deducted from revenue when calculating profits. Provisions, also part of maintenance self-financing, are amounts deducted from income to cover potential future losses, such as a customer defaulting on a debt.

Enrichment: Comprises retained earnings allocated for new investments, enabling company growth. This consists of profits not distributed to shareholders but retained as reserves for future investments. The benefit is realized over several operating cycles and can be materialized in goods and rights. Distributing the entire benefit might necessitate selling part of the fixed assets. Reserves are not paid out, but this carries an opportunity cost and must align with shareholder expectations. A company altering its reserve policy might see a decrease in share price if it fails to meet those expectations.

Advantages of Self-Financing

  1. Provides financial autonomy, reducing dependence on the financial sector, interest rate fluctuations, and system liquidity issues.
  2. Compared to raising capital, it is operationally simpler and cheaper.
  3. Generates higher financial returns by reducing banking and administrative expenses associated with external financing.
  4. This funding source is not subject to taxes.
  5. It has a lower cost than other funding sources.
  6. Increases the book value of each share, potentially motivating future shareholders.

Disadvantages of Self-Financing

  1. May lead to unprofitable investments compared to alternatives rejected due to insufficient resources. Funds might be perceived as ‘free’ and misused.
  2. Can cause shareholder discontent by reducing dividends, as retained earnings are not distributed.
  3. May hinder large, profitable investment projects due to a lack of financial resources.
  4. Lower dividend payments can negatively impact the company’s market value, as shareholders may not receive the expected returns compared to other financial products.

Note on Depreciation: Causes and Types

Depreciation represents the loss of value of an asset over time. There are several types:

  • Functional Depreciation: Loss of value due to wear and tear.
  • Physical Depreciation: Loss of value due to the passage of time, reducing the asset’s operational capacity.
  • Economic Depreciation (Obsolescence): New assets, even in perfect working condition, become outdated.

Obsolescence

  1. Technology: Innovation and technical advances lead to the continuous emergence of new equipment performing the same function more efficiently.
  2. Variations in Demand: Equipment designed for a specific production capacity may become obsolete due to changes in demand. This is often called dimensional obsolescence.
  3. Alteration of Remuneration of a Productive Factor: If a production factor’s cost increases more than inflation and productivity improvements, it may lead to equipment replacement.

Depreciation and Depletion/Expiration: Reversible assets, such as highway concessions and mines, have a limited lifespan. After a certain number of years, the company’s assets expire and revert to the state.