More often than not, internally generated funds represent a major source of capital used by companies, with an average of 60%. It is the responsibility of the finance manager to carefully manage the internally generated funds. Internally generated funds, sometimes called retained earnings are not available for use for free, as some of us may assume. Internally generated funds can easily be defined as surplus funds available after the organization has paid dividends to the shareholders. These retained funds can be used to finance growth (ploughed back) in the organization, replacing obsolete assets, or buying back the shares of the company.
There is an opportunity cost in the use of retained earnings (internally generated funds) because these funds belong to the shareholders who could have received these funds as dividends and invest somewhere else and earn a return. As a result, the cost of using internally generated funds is the current company’s cost of capital. Remember the cost of capital is the return which those who provide finance to the organization expect to earn. The use of internally generated funds comes with many advantages to the finance manager, although with little criticism as well. Before we look into the advantages and disadvantages of retained earnings, let us look at the possible sources of retained earnings.