What Are the Different Sources of Internal Finance?

Geri Terzo

Corporations have choices tied to the profits that are earned each quarter and year. When income exceeds preset expectations, the options become especially compelling. Those profits can be used to reward the equity owners of a corporation, including public investors, or it might be reinvested in the company for specific purposes, such as expansion, acquisition, or other growth plans. Included among sources of internal finance are profits and retained earnings, which is income that is held onto by a company in lieu of distributing the cash to investors in the form of dividend payouts.

Quarterly profits that exceed expectations may be used to pay dividends to shareholders or reinvested in the company.
Quarterly profits that exceed expectations may be used to pay dividends to shareholders or reinvested in the company.

Deciding what to do with profits is one of many choices that companies have when making growth plans. In addition to sources of internal finance, there are choices tied to external financing as well. This represents capital that is generated at a firm by external factors, including investments, loans, and equity-raising efforts. If profits are not sufficient, or if a company's management team has other plans for that income, external financing is a common way for companies to grow.

Sources of internal finance are generated in different ways. For instance, by selling assets that perhaps are no longer part of a company's core business, income can be generated. Or, a company might exceed expectations in sales of a particular product or resource in addition to any other income that might be earned as a result of profits from a previous acquisition or new initiative.

The ways that sources of internal finance are applied vary as well. Income may be used to advance research and development (R&D) at a firm that is seeking growth by acquiring new technologies, for instance. R&D is touted as an acceptable recipient of capital obtained from sources of internal finance, according to some economists. Under economist theory, a slowdown in corporate profits would have a negative impact on the investment into technology for R&D spending.

Companies that historically use profits to pay investors dividends may be limited in uncovering sources of internal finance. Dividends are attractive benefits that investors may rely on in the event a company has a historical track record of distributing profits this way. An interruption in dividend payouts, even if it's for internal financing, may cause investors concern. If a company does make a switch in the way it handles its excess income, the reasons are often explained in a press release or within the confines of a financial statement.

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