Self-financing or internal financing is when the company uses only resources from its own activity to make investments. That is, external funds are dispensed with.
In other words, self-financing means not requesting more bank loans or more contributions from shareholders .
Types of self-financing
There are two types of self-financing:
- Maintenance:It consists of generating resources that allow maintaining the productive capacity of the company.
- Enrichment:It comes from profits not distributed to shareholders in the form of dividends . In other words, it is when the company withholds profits in order to reinvest.
Forms of maintenance self-financing
Within maintenance self-financing we can find two categories:
- Amortization: The company’s machinery and equipment lose value from one period to another. This, regardless of whether or not they are being used in the production process.
This phenomenon is called depreciation . To recognize it, the firm quantifies periodic wear and includes it as a production cost . Said deductions will decrease in time the book value of the asset until it reaches zero.
A good can be fully depreciated, for example, in five years. The discounts that are made in that period serve to accumulate a depreciation fund (or accumulated depreciation). This will serve to replace the equipment.
- Provisions: These are benefits retained by the company to face any identified threat, but that has not yet materialized. The risks can be diverse: The uncollectibilityof a client’sdebt , a lawsuit, among others.
It should be noted that the provisions are reversible. That is, they are removed from the accounting when the loss occurs or if the reason disappears.
Advantages and disadvantages of self-financing
Among the advantages of self-financing are:
- Financial expensesare reduced (interest payments).
- Improves the financial solvencyof the company . With larger equity, the entity will be more reliable with potential creditors .
However, there are also some disadvantages of self-financing:
- It can generate conflicts with shareholdersseeking income in the form of dividends in the short term.
- When profits are not distributed, the attractiveness of the company’s sharesto potential investors falls .
- When the financial expenses arereduced , the profit goes up before taxes and – therefore – the taxes payable. Consequently, the effective cash outflow of the firm can be raised.