Internal sources of capital are those generated within the business. External sources of capital are those outside the business such as suppliers, lenders, and investors. A business can generate capital internally by accelerating collection of receivables, disposing of surplus inventories, retaining profit in the business or cutting costs.
Before seeking external sources of capital from investors or lenders, a business should thoroughly explore all reasonable sources for meeting its capital needs internally. Even if this effort fails to generate all of the needed capital, it can sharply reduce the external financing requirements, resulting in less interest expense, repayment obligations, and sacrifice of control. With lower money needs, the business's ability to secure external financing will be improved. Further, the ability to generate maximum capital internally and to control operations will enhance the confidence of outside investors and lenders. With more confidence in the business and its management, lenders and investors will be more willing to commit their capital.
There are three principal sources of internal capital:
- Increased Earnings Retention
- Asset Management
- Cost Reduction
Increased Earnings Retention
Many businesses are able to meet all of their capital needs through earnings retention. Each year, shareholders' dividends or partners' draws are restricted so that the largest reasonable share of earnings is retained in the business to finance its growth.
As with other internal capital sources, earnings retention not only reduces any external capital requirement, but also affects the business' ability to secure external capital. Lenders are particularly concerned with the rate of earnings retention. The ability to repay debt obligations normally depends upon the amount of cash generated through operations. If this cash is used excessively to pay dividends or to permit withdrawals by investors, the company's ability to meet its debt obligations will be threatened.
Many businesses have non-productive assets that can be liquidated (sold or collected) to provide capital for short-term needs. A vigorous campaign of collecting outstanding receivables, with particular emphasis on amounts long outstanding, can often produce significant amounts of capital. Similarly, inventories can be analyzed and those goods with relatively slow sales activity or with little hope for future fast movement can be liquidated. The liquidation can occur through sales to customers or through sales to wholesale outlets.
Fixed assets can be sold to free cash immediately. For example, a company vehicle might be sold. Instead of owning a company car, owners and employees could be compensated on an actual mileage basis for use of their personal cars on company business. Or, if a vehicle is needed on a full-time basis, it might be leased instead of purchased.
Other assets such as loans made by the business to officers or employees, investments in non-related businesses, or prepaid expenses should be analyzed closely. If they are non-productive, they can often be liquidated so that cash is available to meet the immediate needs of the business.
Any of the above steps can be taken to alleviate short-term cash shortages. On a long-term basis, the business can minimize its external capital needs by establishing policies and procedures that will reduce the possibility of cash shortages caused by ineffective asset management. These policies could include the establishment of more rigorous credit standards, systematic review of outstanding receivables, periodic analysis of slow-moving inventories, and establishment of profitability criteria so that fixed asset investments are most closely controlled.
Careful analysis of costs, both before and after the fact, can improve profitability and therefore the amount of earnings available for retention. At the same time, cost control minimizes the need for cash to meet obligations to trade creditors and others.
Before the fact, a business can establish buying controls that require a written purchase order and competitive bids on all purchases above a specified amount. Decisions to hire extra personnel, lease additional space, or incur other additional costs can be reviewed closely before commitments are made.
After the fact, management should review all actual costs carefully. Expenses can be compared with objectives, experience in previous periods, or with other companies in the industry. Whenever an apparent excess is identified, the cause of the excess should be closely explored and corrective action taken to prevent its recurrence.