Internal finance is money that comes from within a company, rather than from external sources. Companies may use it for investments in lieu of arranging external financing. One advantage to using internal finance for investments is that the company does not incur transaction costs such as origination fees and interest, since the money comes from the inside. Company balance sheets provide information about the amount of money available through internal finance and other financial matters that reflect on a company's financial health.
There are several sources of internal finance. One is depreciation, a tactic that increases cash flow by allowing companies to write down the value of assets over time. Depreciation can be a very powerful accounting tool when it is applied correctly. As assets are depreciated, tax liability decreases, allowing the money to keep funds that it otherwise would have needed to use to pay taxes. This frees up capital for investments and other endeavors.
Retained earnings, also called surplus or undistributed profits, are another source of internal finance. Companies that make payments to shareholders can opt to retain money instead of paying it out to fund investments. This is beneficial for the company in the long term as it increases the possibility for future earnings. Undistributed profits, in other words, do eventually work their way into the hands of shareholders as the company invests that money and increases its profits.
Companies can also raise internal finance by selling off assets for cash. This can include real estate, patents, works of art, and other assets controlled by the company. Sale of assets must be done with care to avoid taking losses or exposing the company to the risk of future losses. Companies in need of cash in a hurry can end up in trouble, as they may be forced to sell assets below market value in order to get cash into company coffers.
When companies are considering new investments, they can weigh available sources of finance to determine which would be most appropriate for a new endeavor. Internal finance can be appealing for certain types of investments, while in other cases, there may be advantages to external financing. Companies that choose to finance through the outside can retain internal funds to cover the company in an emergency, for example. Board members vote on whether or not new investments should be pursued and the type of financing the company should use.