Finance is a constant requirement for every growing business. Raising funds required can be achieved through a variety of sources. It is important that we understand the characteristics and cost of each source.
The following is a list of some internal ways to generate finance in your business. Internal Sources of Finance are the sources of capital that the business can generate itself in its normal course of operations.
These are particularly important for small businesses that are trying to grow. Obtaining funding when you are a small business can often be quite difficult. As a result, these internal sources can prove to be vital sources.
Short-Term Sources of Finance
1) Tighter Credit Control
Tighter credit control over amounts owed to us by our credit customers and ensuring that all accounts are promptly followed up can provide us with an opportunity to decrease the amount of money tied up in this form. These funds can then be used in other profit generating activities.
Despite the benefits that freeing up assets held in this form will bring, exerting tighter credit control can lead to a loss of customer goodwill and sales. We must take into account the needs of our customers as well as the credit policies of our competitors so that we still remain attractive.
2) Delay Payment to Suppliers
When a supplier provides us with a credit period, they are in essence offering us an interest-free loan. By delaying payment to a supplier we are effectively stretching the period of the loan and retaining the funds in our business. These funds can then be used for another purpose to generate profit.
While this appears tempting, it’s important to consider that costs may be incurred if we extend the period beyond the agreed limit with our supplier. Such costs include interest charges, loss of our discount and the goodwill of that supplier. Our reputation could also be affected, which in turn could have an adverse effect on our ability to obtain credit from other suppliers.
If you have a good relationship with your supplier, you may be able to establish an agreement with them to extend your period of credit during a time of crisis etc. This way you avoid the risks of additional costs and loss of goodwill.
3) Reduce Stock Level
Holding a large quantity of stock prevents the funds tied up in this form from being spent in other areas. Decreasing inventory to the level required to satisfy future sales orders will allow us to use the funds in profitable activities.
We must ensure that sufficient stock is available to meet anticipated future sales demands. Failure to satisfy customers orders could lead to a loss of goodwill. Also, what if an unexpected large order comes in?
Reducing our stock level contributes to lower stock holding costs, better cash-flow and reduces the risk of obsolete stock. However, it is important to note that this can only be achieved where the excess stock is not as a result of a poor buying decision or obsolete. Otherwise, it may be difficult to convert to liquidate.
4) Delay Payment of Accruals
An accrual is an expense that we have incurred but have not yet pay for. Our electricity bill would be an example of an accrual. We have used the electricity for the month but we have not yet paid for it. If we delay the payment of this bill for as long as possible we can use those funds for other activities.
This relatively small source of finance is not cost free. Interest may be incurred on overdue payments. It can have a negative impact on our reputation while contributing to a loss of confidence in the operating capabilities of our business.
5) Deferred Income
We can ask our customers to pay some or all of the invoice amount in advance. This is a great way to reduce the risk of bad debts. Also, it decreases the amount of funds tied up in credit sales. These funds can now be used in other transactions to generate additional profit for our business.
Long-term Source of Finance
6) Retained Earnings
Using earnings generated to reinvest in our business is a long-term source of internal finance. While it is an important source of finance for any business, it is not free. If we had distributed those earnings to the shareholders (owners) they could have used them to invest in other profit generating investments. By retaining them in the business we have prevented the shareholders from doing this. As a result, this represents a cost to those shareholders.
Reinvesting earnings made can be a very useful way of raising finance as it incurs no issues costs which can be quite substantial. Issues costs would be incurred if we were to try raise finance via the issue of new shares. The success of an issue of shares carries an element of uncertainty. This uncertainty does not exist when reinvesting our earnings in the business. The amount of earnings available to reinvest will be certain when the earnings are made.
Control will not be impacted when using earnings as a source of funding. Whereas issuing new shares will result in a dilution of control among existing shareholders. Also, earnings are already held, therefore there is no delay in receiving the funds. When we raise finance through equity, we must issue shares and get investors to subscribe.
There are many benefits to using earnings as finance to fund a project but consideration must be given to some of the drawbacks. Retaining earnings rather than distributing them to shareholders can turn away potential investors. Existing shareholders may require a higher rate of return in future years as compensation.
While the earnings amount may be certain when we have actually made it, planning ahead can be difficult. The timing and amount of profits can be difficult to estimate.
Discipline can be another concern. When we borrow from a bank we are obligated to meet regular interest and capital repayments. This imposes a tighter discipline on us when managing our business. We need to ensure we have the cash available to meet this obligation when they fall due. When using earnings, we do not have such obligation. There is no fixed obligation of interest or instalment payments.
As a result, there is a risk that we may not be as careful as we would be with a loan from a bank.
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