In the theory of capital structure

Capital structure

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...

, internal financing is the name for a firm

Business

A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...

 using its profits

Profit (accounting)

In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...

 as a source of capital for new investment

Investment

Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

, rather than a) distributing them to firm's owners or other investors and b) obtaining capital elsewhere. It is to be contrasted with external financing

External financing

In the theory of capital structure, External financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment. There are many kinds of external financing...

 which consists of new money from outside of the firm brought in for investment. Internal financing is generally thought to be less expensive for the firm than external financing because the firm does not have to incur transaction costs to obtain it, nor does it have to pay the taxes associated with paying dividends. Many economists debate whether the availability of internal financing is an important determinant

Determinant

In linear algebra, the determinant is a value associated with a square matrix. It can be computed from the entries of the matrix by a specific arithmetic expression, while other ways to determine its value exist as well...

 of firm investment or not. A related controversy

Controversy

Controversy is a state of prolonged public dispute or debate, usually concerning a matter of opinion. The word was coined from the Latin controversia, as a composite of controversus – "turned in an opposite direction," from contra – "against" – and vertere – to turn, or versus , hence, "to turn...

 is whether the fact that internal financing is empirically correlated with investment implies firms are credit constrained

Liquidity constraint

A liquidity constraint in economic theory is a form of imperfection in the capital market. It causes difficulties for models based on intertemporal consumption.Many economic models require individuals to save or borrow money from time to time....

 and therefore depend on internal financing for investment.

Financing options

There exist several options for a company to finance itself without external help:

- Amortization

Amortization

Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...

 (deduction of asset value narrows profit before tax),
- Building reserves

Bank reserves

Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...

 (e.g. pension reserves),
- Retained earnings

Retained earnings

In accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or...

 (earning are not paid to company owners),
- Asset swaps (e.g. selling property or other tangible assets owned by the company)

Advantages & Disadvantages of internal financing

Advantages
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- Capital is immediately available

- No interest payments

- No control procedures regarding creditworthiness

- Spares credit line

- No influence of third parties

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Disadvantages
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- Expensive because internal financing is not tax-deductible

- No increase of capital

- Not as flexible as external financing

- Losses (shrinking of capital) are not tax-deductible

- Limited in volume (volume of external financing as well is limited but there is more capital available outside - in the markets - than inside of a company)

External links

• Definition at investor words.