Company Financing: Internal and External Capital Sources

Company Financial Function: Securing Investment Capital

The primary financial function of a company is to obtain the necessary financial resources to undertake investments. In accounting terms, assets represent investments, while financial liabilities are comprised of both own sources of financing (such as equity, reserves, and depreciation) and external sources (like loans, leasing, and credit).

Own Financing (Self-Financing)

Also known as self-financing, this refers to all financing activities within a company that are achieved through the profits it generates internally, without distributing these benefits to its owners. It primarily involves an increase in own sources, particularly from the reserve account.

Advantages of Own Financing

• Cost-Free Capital: It has no direct financial cost.
• Financial Independence: The company is financially independent and not reliant on third parties.

Disadvantages of Own Financing

• Shareholder Perception: It may negatively impact the company's image or the opinion of shareholders, which can be crucial if an extension of capital is needed.

External Financing

External financing involves unrelated third parties providing funds to the company.

Disadvantages of External Financing

• Financial Cost: It typically carries a financial cost (e.g., interest).
• Repayment Obligation: Funds must be repaid within an agreed-upon period.

Specific Own Sources of Funding

1. Capital Resources

These are funds contributed by members or owners to finance the company. Partners contribute capital in exchange for a share of company profits, often in the form of dividends.

2. Reserves

Also called self-enrichment, reserves consist of profits not distributed among the members of the company, but retained to expand future capacity and generate more benefits.

Types of Reserves

• Legal Reserve: Requires a Public Limited Company (SA) to allocate 10% of its profits to a legal reserve until it reaches 20% of the share capital.
• Statutory Reserve: Established by the company's own statutes.
• Voluntary Reserve: Freely established by the company as it deems fit.
• Reserve for Premium: Appears when shares are issued at a price higher than their nominal value.

3. Depreciation

Also known as self-maintenance, depreciation represents the irreversible loss of value of fixed assets over time. Before the time comes to replace these fixed assets, the accumulated depreciation can be utilized as a funding source to make new investments that could yield a return superior to the initial investment cost.

4. Provisions

Provisions are sources of funds set aside to meet certain losses that have not yet occurred, or to cover future expenses like compensation, taxes, etc.

Overall Considerations for Own Financing

Advantages

• Independence: Does not depend on external parties.
• Tax Effect: Can have a positive tax effect.
• Investment Incentive: Encourages company investment and growth.

Disadvantages

• Risk of Unprofitable Investments: May lead to investments that are unprofitable if the opportunity cost of self-financing is not properly considered.
• Dividend vs. Retention Balance: A balance must be found between distributing dividends to shareholders and retaining profits for internal funding.