In general, self- financing differs from financing through external funds. The self-financing of companies is about the fact that the profits generated are not distributed, but remain in the company. Self-financing belongs to the self-financing category. In a broader sense, it is also referred to as internal financing or profit retention. But when does one speak of self-financing? How can self-financing be carried out? What does this include and what options do I have for this financing?
Self financing definition and explanation
Self-financing is part of internal financing and one speaks of financing through asset growth . Means that profits are not paid out to the shareholders, for example, but are intended to finance something and remain in the company. This eliminates the need to accept loans from banks or investors. The company remains through no fault of its own and does not have to pay any interest. The more profits a company saves, the higher the equity for later investments . As a result, new machines can be bought or liabilities to third parties can be repaid.
Of course, the process of self-financing differs depending on the legal form of the company. Corporations, however, have to proceed differently than sole proprietorships or partnerships . Let us first differentiate between two types of self-financing: open self-financing and silent self-financing. What does that mean?
The degree of self-financing
The degree of self-financing corresponds to the amount at which a company can finance things from its own resources. It is all about equity . The degree of self-financing is always given as a percentage and calculated using a formula. The degree of self-financing is an important criterion for granting loans. The question arises to what extent a company can cover its financing from its own resources without having to resort to outside capital.
In order to determine the degree of self-financing, the equity is compared to the total capital. The ratio between debt and equity can now be specified by means of a key figure. The higher this figure, the higher the share of equity and thus the degree of self-financing.
The formula for this is: Degree of self-financing = retained earnings / equity .
Banks can now make an assessment of the creditworthiness.
The open self-financing
According to sportingology.com, with open self-financing, revenue reserves are actively created in order to increase equity. One speaks of internal financing. In plain English, this means: Taxed profits are retained and added to the retained earnings. Now equity increases through this retention of profits . Various depreciation, dividends and taxes are also taken into account. Of course, this is not a special tactic, but a sorted calculation. These surpluses are to be assessed individually in the balance sheet . A distinction must be made here between statutory and statutory reserves , reserves for own shares and revenue reserves.
In the case of partnerships or sole proprietorships, withholding profits can increase the capital account. The open self-financing is shown in the balance sheet.
The silent self-financing
The silent self-financing can also be called covert self-financing . Here, the company dissolves hidden reserves or hidden reserves. These are assets that are not openly disclosed in the balance sheet.
The asset side of a company is thus undervalued, which means that the hidden reserves are only taxed upon dissolution. Assets are available assets with which the company is actively working, such as machines from the fixed assets. For example, the machine is written off more heavily than necessary.
In the case of hidden reserves, the liabilities are overvalued. The liabilities describe the extent to which the company was financed by equity or debt. Means debt becomes overvalued, which reduces the company’s profit and reduces taxes.
How does self-financing work?
The process of self-financing can take place in different ways, again depending on the legal form of the company. A distinction must be made here between sole proprietorships and partnerships, as well as corporations:
Sole proprietorship & partnerships
These companies do not have to report their retained earnings in a separate line item on the balance sheet. The reason: The reserves are accumulated in the equity account and thus increased. This means that companies have more equity available, which of course increases their creditworthiness vis-à-vis third parties.
In the case of corporations , it is a bit more complex, because there is a “retained earnings” item in the balance sheet. The shareholders decide whether reserves are to be formed from the profits at all. In the case of stock corporations , this can only happen up to 50% without the consent of the shareholders. The shareholders then decide on the other 50% at a general meeting. The capital gained through self-financing then leads – if the share capital of a stock corporation remains unchanged – to increasing market values of the shares.