Self-financing: the advantages and risks linked to this method of financing

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The financing of a company can have two different origins: either through external capital, such as fundraising and loans, or through equity. The latter case is called self-financing.

Self-financing then represents an internal financing method which reflects the ability of a company to finance its activity and its investments using its own financial means and without any external intervention.

What is self-financing?

At the level of a company, self-financing consists of using one’s own cash flow to finance any investment. Thus, the company concerned uses the profits that it has actually generated in previous years and which have not been withdrawn or distributed. In this sense, a company is said to be profitable if its activity is profitable and if the result it generates is not redistributed.

From an accounting point of view, self-financing corresponds to the result made by the company after the deduction of taxes and which is not distributed. This element is found at the liability level of the balance sheet, more precisely at the level of reserves or carried forward results.

To self-finance, a company can, firstly, draw on its capital gains, in particular the positive difference it makes between the value of its produced goods and its expenses, for example the price of salaries and production costs. Likewise, she can use her savings, in particular the sums she has put in reserve and which were not allocated to her consumption. The company can also use its own capital, or even funds provided by shareholders, associates or by the results of the entity itself. Finally, to ensure its self-financing, the company can use its accounting depreciation, which corresponds to the spread of the cost of any investment over its observed useful life.

The self-financing capacity of the company can be calculated each year from the results achieved. This capacity brings together all the internal resources that the company generates from its activity.

Self-financing or debt, which option to choose?

Financing investments is crucial to ensuring the sustainability of a business. In this context, the company has two alternatives: self-financing and recourse to loans.

The use of loans is mainly the alternative chosen by prudent companies that do not wish to weaken healthy cash flow. Likewise, this option generates a leverage effect on the financial profitability of the entity, depending on the cost of the loan. Thus, in the case where the cost of borrowing is lower than the possible profitability of the investment, the profitability of the company’s equity will improve. Self-financing is mainly adopted for short-term financing.

The choice between self-financing and debt must also take into account the return on capital, in particular the distribution of dividends. Moreover, significant self-financing can cancel out the remuneration of investors, who expect returns on their investments.

Furthermore, it is possible to opt for both alternatives in order to ensure the sustainability of the company and meet the interests of its investors.

The advantages of self-financing

Self-financing can constitute a strategic source of financing for the company. In fact, it allows it to relatively increase its equity if the investment project is successful and thus increase its value. Likewise, self-financing makes it possible to possibly carry out a capital increase and improve most financial ratios.

Furthermore, by opting for self-financing, the company uses its own means for financing, which gives it total freedom to choose the allocation appropriate to its needs. Thus, it will be able to finance its growth, its investments and even repay its debts on its own terms and without the need for external funds. This also results in a reduction in its dependence on its donors.

A company that chooses self-financing also has the opportunity to prove the profitability of its business model and considerably improve its credibility, with its partners and with its customers.

The risks associated with self-financing

Recourse to self-financing may present certain risks for the company. Indeed, the company concerned must necessarily verify that it has sufficient resources, which allow it to make new investments, to choose this financing option. Likewise, it is important to study potential investment projects as they may prove unsuccessful, and therefore result in big losses for the company as well as its shareholders

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