Types of self-financing
Every company needs a corresponding amount of equity, of course depending on the entrepreneurial situation. It often makes sense to increase your existing equity. For example, through self-financing or self-financing. However, this includes various measures that a company can use. At this point we differentiate between internal and external financing. The decisive factor here is what purpose the equity capital should serve.
Internal financing in companies
The capital comes directly from the company, for example due to generated surpluses that are simply retained. The money is added to the existing equity. This process is also known as retained earnings . At this point, hidden self-financing is common, i.e. the release of hidden reserves that increase equity. This can be implemented, for example, through high depreciation or non-capitalization of various assets that have a low value. This leads to an undervaluation of assets and, at the same time, an overvaluation of liabilities .
External financing
External financing can also be an option to increase the company’s equity. For example, by issuing shares. Shareholders receive company shares for providing the company with capital. They then become co-owners. At this point, the term equity financing is more appropriate, because in this case it belongs to the types of external financing. The capital invested is part of the company’s private assets.
Self-financing example
According to topbbacolleges.com, a concert promoter generates a turnover of 2,300,000.00 euros within one financial year. The personnel costs of 500,000 euros and the cost of raw materials and supplies of 1,200,000.00 euros can now be deducted from this. Other expenses add up to 250,000 euros. The profit BEFORE taxes for the organizer is therefore 350,000.00 euros.
The organizer could now distribute or distribute this money to its business partners. However, since the entrepreneur urgently needs a new vehicle for approx. If he needs 50,000 euros for his activities, he can do without outside financing and withhold the profit.
Advantages and disadvantages of self-financing
Advantages of self-financing
Self-financing can offer companies several advantages. For example, with external financing, interest is incurred, which a company must also take into account. It is therefore often cheaper to cover the required capital through self-financing.
In addition, an increase in equity usually translates into a better valuation of the company. A positive sign for the future development of a company. In addition, self-financing makes companies less dependent on other companies. In this way, you can use your capital very flexibly and do not have to deal with the purpose of a loan. Companies can react flexibly and at short notice without having to justify themselves to creditors or lenders.
In bad economic situations, outside capital can put a strain on a company’s liquidity. Finally, in addition to the repayment installments, interest must also be paid. Self-financing offers greater protection against insolvency.
Disadvantages of self-financing
If the hidden reserves of a company have to be released, taxes are due on these. This also affects the company’s liquidity due to the subsequent taxation. Conflicts can also arise under certain circumstances if, for example in a stock corporation, not all shareholders agree with the procedure. The tradability of the shares is also reduced due to the rising market values, and the falling dividend yield can also be a disadvantage, as it is an important indicator for the evaluation of securities.
Depending on the distribution of profits and the development of tax rates, companies either experience a tax burden or a tax relief. Here entrepreneurs have to assess for themselves which path they are going to take. Fortunately, the tax legislator has drawn up a list of possible special depreciation. In this way, companies can quickly find out whether the formation of hidden reserves is permissible and therefore sensible.
Why does a company need equity?
Of course, debt financing may be much easier in some cases, but many prefer self-financing. And that can have advantages, because the capital is not only available to the company in the short term, but in the long term. The company is not bound by repayment obligations , which are accompanied by corresponding interest. Especially in times of crisis, when banks sometimes do not grant loans, self-financing can even be the only option. In addition, the level of equity is also decisive for the company valuation. The higher the share of equity, the better the creditworthiness. Anyone looking for investors can score points in this way. And when it comes to lending, it can also be helpful to already have security in the company. Equity is therefore also required for external financing and is used for security.
