This article throws light upon the top two sources of internal financing for existing concerns. The sources are: 1. Ploughing Back of Profits 2. Depreciation as a Source of Funds.
Internal Financing for Existing Concerns: Source # 1.
Ploughing Back of Profits:
The ‘Ploughing Back of Profits’ is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend, but a part of the profits is retained or reinvested in the company. This process of retaining profits year after year and their utilisation in the business is also known as ploughing back of profits.
It is actually an economical step which a company takes, in the sense, that instead of distributing the entire earnings by way of dividend, it keeps a certain percentage of it to be re-introduced into the business for its development Such a phenomenon is also known s ‘Self-Financing’; Internal Financing’; or ‘Inter – Financing’.
A part of profits is ploughed back or re-employed into the business and is regarded as an ideal source of financing expansion and modernisation schemes as there is no immediate pressure to pay a return on this portion of stockholders’ equity. Under this method, a part of total profits is transferred to various reserves such as General Reserve, Replacement Fund.
Reserve Fund, Reserve for Repairs and Renewals, etc. Sometimes ‘secret reserves’ are also created without the knowledge of the shareholders. From all the practices of financial management, this system of ploughing back of profits is considered desirable as it helps in the financial and economic stabilisation of the concern.
The Necessity of Ploughing Back:
The need for re-investment of retained earnings or ploughing back of profits arises for the following purposes:
i. For the replacement of old assets which have become obsolete.
ii. For the expansion and growth of the business.
iii. For contributing towards the fixed as well as working capital needs of the company.
iv. For improving the efficiency of the plant and equipment.
v. For making the company self-dependent of finance from outside sources.
vi. For redemption of loans and debentures.
Factors Influencing the Re-investment of Profits or Ploughing-back of Profits:
The tool of ploughing back of profits can be successfully employed only by those concerns which have stable earnings, further; there are a number of factors that influence the ploughing back of profits in a concern:
i. Earning Capacity:
Ploughing-back of profits depends largely upon the earnings capacity of the economy. If a concern does not earn sufficiently, there is no possibility of ploughing-back of profits. Usually, greater is the earning capacity of a company, larger is the possibility of ploughing-back of profits.
ii. Desire and Type of Shareholders:
The policy of ploughing back of profits is also affected by the desire and type of its shareholders. If shareholders largely belong to the class of retired persons, widows and other economically weaker persons, they may desire maximum distribution of profits as dividend. On the other hand, a wealthy investor may not mind if the company retains a portion of profits for future development.
iii. Future Financial Requirement:
Future financial requirements of the company also affect the policy of ploughing back of profits. If a company has highly profitable investment opportunities for future development, it may plough back its profits more successfully.
iv. Dividend Policy:
The re-investment of profits depends to a great extent upon the dividend policy of the company. If a company desires to plough back profits it cannot follow a policy of a very high dividend payout.
v. Taxation Policy:
The taxation policy of the Government also affects the re-investment of profits. A high or low rate of business taxation affects the net earnings of the company and thereby its re-investment policy.
Internal Financing for Existing Concerns: Source # 2.
Depreciation as a Source of Funds:
Depreciation may be regarded as the capital cost of assets allocated over the life of the asset. In simple language, it means the gradual decrease in the value of an asset due to wear and tear, use, and passage of time. In real sense, depreciation is simply a book entry having the effect of reducing the book value of the asset and the profits of the current year for the same amount.
It does not affect current assets or current liabilities and does not result in the flow of funds or to say more precisely it is a non-fund item. Hence, although depreciation is an operating cost there is no actual outflow of cash and so the amount of depreciation charged during the year is added back to profits while finding funds from operations. But, then, is depreciation a source of funds?
There cannot be any definite answer in ‘yes’ or ‘no’ to this question as there is difference of opinion on this important point. But it can be said with certainty that depreciation, directly at least does not amount to a source of funds.
However, under certain circumstances, depreciation helps a business concern to effect sayings in payment of tax and dividends and amounts to withholding a part of the funds generated through normal trading operations.
It is in this sense that depreciation can be regarded as an indirect source of funds. However, it is not even an indirect source of funds under all circumstances. Say, for example, a company is running into losses and there are no profits, then any amount of depreciation charged to profit and loss account will neither affect tax liability nor any payment of dividends, as there are no profits.
In this case, depreciation does not amount to withholding of funds and, hence, is not a source of funds at all.
On the other hand, if a concern earns sufficient profit then the amount of depreciation charged to profit and loss account will affect savings in the payment of tax as well as dividend and shall help in the generation of funds.
In case a concern earns huge profit and excessive depreciation than permitted under the Income-tax Act is charged to profit and loss account, it shall still result in the generation of funds through savings in the payment of dividends.
To conclude, it may be said that to the extent depreciation helps in effecting savings in the payment of tax and dividend, it may be regarded as a source of funds.