Self-Financing - Term Overview

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Self-financing or internal financing is when the company uses only the resources from its own activity to make investments. In other words, external funds are dispensed with.

In other words, self-financing means not requesting more bank loans or more contributions from shareholders.

Types of self-financing

There are two types of self-financing:

- Maintenance: Consists of generating resources that allow maintaining the productive capacity of the company.
- Enrichment: It comes from the profits not distributed to shareholders in the form of dividends. In other words, it's when the company retains earnings in order to reinvest.

Forms of maintenance self-financing

Within maintenance self-financing we can find two categories:

Amortization: The machinery and equipment of the company lose value from one period to another. This, regardless of whether or not they are being used in the production process.

This phenomenon is called depreciation. To recognize it, the firm quantifies periodic wear and tear and includes it as a cost of production. Said deductions will decrease over time the book value of the asset until it reaches zero.

An asset can be fully depreciated, for example, in five years. Discounts made within that period are used to accumulate a sinking fund (or accumulated depreciation). This will serve to replace the equipment.

Provisions: These are benefits retained by the company to face any identified threat, but which has not yet materialized. The risks can be diverse: The bad debt of a client, a lawsuit, among others.

It should be noted that the provisions are reversible. That is, they are removed from the accounting when the loss occurs or if the reason disappears.

Advantages and disadvantages of self-financing

Among the advantages of self-financing are:

Financial expenses (interest payments) are reduced. Improves the financial solvency of the company. With higher own funds, the entity will be more reliable with potential creditors.

However, there are also some downsides to self-financing:

- It can create conflicts with shareholders seeking income in the form of dividends in the short term.
- When profits aren't shared, the attractiveness of the company's shares to potential investors falls.
- By reducing financial expenses, profit before taxes increases and, therefore, taxes payable. Consequently, the firm's effective outflow of money can be raised.

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