The following are the sources of long-term sources working capital or long-term sources of finance:
1. Internal Financing Sources, and
2. External Financing Sources
Internal Financing Sources
As we have classified the source of finance as internal and external, which is based on the generation of finance source. A new company can raise the required long-term sources funds from external sources, but an undertaking, which is well established, can generate funds not only from external sources but also from internal sources. The internal source of finance is available only for firms that are existing and well established.
The internal sources of finance are:
1. Retained earnings/ploughing back of profits, and
2. Depreciation charges.
The following discussion gives a clear view about the internal sources of finance.
Retained Earnings/Ploughing Back of Profits
Retained earnings is an important source of internal financing of well-established companies. Retained earnings are the portion of earnings available to equity shareholders, which are ploughed back in the company. In other words, a part of earnings available to equity shareholders that are retained for future investment. Accumulation of profits by a firm for
financing developmental programmes. Hence, the process of accumulating company profits regularly and their utilisation in the business is known as retained earnings or ploughing back of profits or internal financing or self-investment. Retained earnings are part of equity since they are part of equity, which is sacrificed by equity shareholders. In this source of finance companies, generally retained or ploughed back about 20 per cent to 70 per cent of earnings available to equity shareholders for the purpose of financing of the growth of the company. This becomes the main source of long-term finance when the management capitalises profits. It is known as capitalization of profits or issue of bonus shares.
Retained earnings may be used for expansion programmes of the company, replacement of obsolete assets, modernization of plant and equipment, the redemption of preference shares or debentures, loans etc.
Depreciation is the distribution cost or the basic value of tangible capital assets, over the estimated useful life of the asset in a systematic and rational manner. In other words, depreciation is the allocation of capital expenditure to various periods over which the capital expenditure is expected to benefit the company. For example, a machinery costing Rs. 1,00,000, has 5 years life period with no scrap value. If the machine is depreciated based on straight line method of depreciation, the depreciation charge for a year is Rs. 20,000 (Rs. 1,00,000 / 5), which is shown in profit & loss account debit side and it reduces profit by Rs. 20,000. But it is only book entry and not a cash outflow. It is out of pocket cost. There is a lot of debate among academicians and business executives regarding the treatment of depreciation as a source of finance. Whatever may be the arguments either for or against, but one thing is clear that it is an out of pocket cost or non-cash item of expense. Hence, it is considered as an internal source of finance.
External Financing Sources
A share is a small unit of the capital of a company. In other words, share capital of a company (planned to raise) divided into a number of equal parts that known is share. Section 2 (46) of the Companies Act, 1956, defines share as, “a share in the share capital of a company and includes stock, except when a distinction between stock and share is expressed or implied”. It is a legal definition of share. Stock and share have different meanings. According to Section 94 (i)(c) of the Companies Act, 1956 stock means, a share, which is fully paid up. Lord Justice James Lindley gives a good definition, as “A share is that proportionate part of capital to which a member is entitled.” For example, XYZ company has a share capital of Rs. 1,00,000, of Rs. 10 each. Then the capital is divided into 10,000 shares (i.e., Rs.1,00,000/Rs.10). A shareholder is a person who buys one or more shares in the company.