KEY POINT
The main internal source of finance is retained earnings (accumulated profits). Internal finance can also be generated by increasing efficiency in working capital management.
1.1 Pecking Order Theory
Company managers may prefer to use internal finance rather than external finance for the following reasons:
A belief that using internal finance costs nothing. In fact, this is not true as retained earnings belong to the shareholders who expect significant returns.
Avoids the issue of information asymmetry. External investors do not have as much knowledge of the business as the management, and are therefore often reluctant to provide finance or will only provide it at high cost. This is particularly significant for small and medium-sized entities (SMEs), which often have problems attracting new investors due to little public knowledge of the business. Using internal finance avoids the problem.
There are no issue costs on internal finance, whereas the cost of issuing new shares can be significant.
It does not result in a change of the control structure.
Shareholders may prefer capital gains over dividends due to taxation issues (e.g. in the UK, individuals are given a large tax-free limit on capital gains).
Sensitive information about projects does not need to be released (as compared to a share issue, which could require a prospectus).
Internal finance can be done immediately, and this speed compares favourably to a share issue, which can take many months.
This preference for internal finance is known as the "pecking order theory" and is supported by research that found company directors often choose "the path of least resistance" when it comes to financing.
1.2 Working Capital Management
Creating accounting profits does not guarantee the availability of internal equity finance, as the company must also be converting the profits into positive cash flows. Thus, a company's ability to generate internal finance depends on its ability to generate operating cash flow in excess of interest and taxes.
Potential internal finance available = operating cash flow – interest – tax
As interest and tax are committed costs, the focus must be on maximising operating cash flows.
Operating cash flows are calculated as follows:
Earnings before interest and tax, depreciation and x
amortisation (EBITDA)
Rise/fall in inventory (x)/x
Rise/fall in receivables (x)/x
Rise/fall in payables x/(x)
Operating cash flow x
Improved working capital management can help to release more internal equity finance. Potential areas for improvement include:
Reducing the time taken to receive payments from customers (e.g. by offering discounts for quick payment or outsourcing debt collection to a factor).
Reduction in the amount of inventory (e.g. through improved supply chain management or even moving to Just-in-Time (JIT) production).
Taking increased credit from suppliers. However, care must be taken not to lose settlement discounts or compromise relationships with key suppliers.
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