Internal Funds

Every firm has the need to raise capital (funds) in order to finance the necessary purchase of assets (such as inventories and manufacturing plants) to run its business. While smaller amounts of financing are available from short-term sources for business operating needs (such as inventory or short-term working capital needs), larger amounts of capital are of a more permanent or long-term nature. The permanent/long-term sources of financing that a company uses are referred to collectively as the company’s capital structure.

The capital structure of a firm includes the long-term liabilities and equity sections of its balance sheet. Long-term liabilities and equity indicate how the company obtained the necessary money to buy the assets the company holds. In contrast to the working capital area, a firm’s capital structure relates to the firm’s permanent and long-term financing.

The sources of permanent and long-term financing may be broken down into external and internal sources.

Internal Funds

Internal funds are available from profits the company generates but does not distribute to the stockholders. These retained earnings of the company are available as a source of capital. The advantage of internal sources of capital is that there is no cash cost (interest or dividends) to the company associated with these funds. the shareholders will expect the company to provide a return on the profits that the company does not distribute. So, while there is no cash cost to retained earnings, the shareholders do have a required return that they expect the company provide.