TEACHING BLOCKS

Internal funding sources

 Concepts and modalities
 Retained earnings
 Economic depreciation
 Causes of depreciation

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 Internal Financial Sources
CONCEPTS AND MODALITIES
Instead of borrowing from investors (bondholders or shareholders) and
bankers, companies have the option of using the money generated by the
business itself.

The most of this approach – it saves money on interest payments and free
companies from bankruptcy.

The least of this approach - it can limit expansion options, if there is not
enough cash available to proceed with the strategical plans

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 Internal Financial Sources
FIRM’S INTERNAL FINANCIAL SOURCES

Retained earnings

Depreciation (amortization)*

• Depreciation is for fixed assets and amortization for intangible assets.

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 Internal Financial Sources
Retained earnings (reserves).
• Retained earnings is the percentage of earnings not paid out as dividends, but
retained by the company to be reinvested in its core business, or to repay debt.

RETAINED EARNINGS (RE) = EARNINGS - DIVIDENDS

Depreciation (depreciation + amortization)

• Reduction in the book or market value of an asset
It is a non-cash expense but it is an accounting method of allocating the cost of a
tangible asset over its useful life. Businesses depreciate long-term assets for both
tax and accounting purposes
• CONCEPT
Depreciation is the portion of an investment that can be deducted from taxable
income. It is a non-cash expense that reduces taxable income, providing a tax shield
equal to the product of depreciation and the marginal tax rate. The higher is the
depreciation, the higher will be the tax shield

TAX SHIELD = DEPRECIATION (AMORTIZATION) x MARGINAL TAX RATE

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 4

 Internal Financial Sources

- Retained earnings (reserves)

- Depreciation (depreciation + amortization)

Advantages:
- Less costly.
- Tax advantages (Depreciation).
- Higher solvency and financial autonomy.

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 5

 Internal Financial Sources
- Retained earnings (reserves).
- Depreciation (depreciation + amortization).

Disadvantages:
- Lower profitability (Depreciation)
- Lower ROE
- Risk of idle resources and high risk investment

Net income
ROE 
Equity

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 Internal Financial Sources

Reserves:

All retained earnings are Reserves, but not all Reserves are
retained earnings.
Examples:
- Balance sheet update - generated Reserves
- Issue premium - Reserves
- Secret Reserves (accounting practices)
- Hidden Reserves (market value)

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 7

 TEACHING BLOCKS
Internal funding sources
 The financial function of depreciation

 Economic depreciation versus financial depreciation

 The multiplier effect of self-financing

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 8

 Internal Financial Sources
Depreciation as a Financial Source:
- Depreciation is a non-cash expense.
- Depreciation is an expense that reduces the net income.

By reducing the net income,

Depreciation reduces tax payment as well.

By reducing the net income, Depreciation reduces dividends payment.

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 Internal Financial Sources

INCOME STATEMENT
SALES
- COST OF GOODS SOLD
GROSS PROFIT
- OPERATIONAL COSTS
EARNINGS BEFORE INTEREST DEPRECIATION AND AMORTIZATION = EBITDA
- DEPRECIATION AND AMORTIZATION
EARNINGS BEFORE INTEREST AND TAXES = EBIT
- INTERESTS
EARNINGS BEFORE TAXES = EBT
- TAXES

NET INCOME = NI
ALLOCTION OF NET INCOME
DIVIDENDS
RETAINED EARNINGS (RE)

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 Internal Financial Sources

DEPRECIATION AS A FINANCIAL SOURCE

Suppose: Depreciation = 200.000 Taxes = t= 30% and pay-out =50%

WITH DEPRECIATION INCOME STATEMENT WITHOUT DEPRECIATION DIFFERENCES
1.000.000 EBITDA 1.000.000 0
200.000 Depreciation 0 -200.000
800.000 EBIT 1.000.000 200.000
50.000 Interests 50.000 0
750.000 EBT 950.000 200.000
225.000 Taxes 285.000 60.000
525.000 Net Income 665.000 140.000
262.500 Dividends 332.500 70.000
262.500 RETAINED EARNINGS 332.500 70.000

Cash-Flow = 525.000 + 200.000 = 725.000 (with depreciation)

Cash-Flow = 665.000 (without depreciation)
Difference = 725.000 – 665.000 = 60.000 = Tax shield
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 Internal Financial Sources

DEPRECIATION AS A FINANCIAL SOURCE

Suppose: Depreciation = 200.000 Taxes = t= 30% and pay-out =50%

WITH DEPRECIATION INCOME STATEMENT WITHOUT DEPRECIATION
1.000.000 EBITDA 1.000.000
200.000 Depreciation 0

800.000 EBIT 1.000.000

50.000 Interests 50.000
750.000 EBT 950.000
225.000 Taxes 285.000
525.000 Net Income 665.000
262.500 Dividends 332.500
262.500 RETAINED EARNINGS 332.500

DIFFERENCES ON TAXES = TAX SHIELD = 285.000 – 225.000 = 60.000 = 0,30 * DEPRECIATION

DIFFERENCES ON NET INCOME = 665.000 – 525.000 = 140.000 = DEPRECIATION – TAX SHIELD
DIFFERENCES ON DIVIDENDS = 332.500 – 262.500 = 70.000 = 50% * DIFFERENCES ON NET INCOME

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 Internal Financial Sources
DEPRECIATION AS A FINANCIAL SOURCE

Suppose: Depreciation = 200.000 Taxes = t= 30% and pay-out =50%

WITH DEPRECIATION INCOME STATEMENT WITHOUT DEPRECIATION
1.000.000 EBITDA 1.000.000
200.000 Depreciation 0

800.000 EBIT 1.000.000

50.000 Interests 50.000
750.000 EBT 950.000
225.000 Taxes 285.000
525.000 Net Income 665.000
262.500 Dividends 332.500
262.500 RETAINED EARNINGS 332.500
TAXES AND DIVIDENDS (with Depreciation) = 225.000 + 262.500 = 487.500
TAXES AND DIVIDENDS (without Depreciation) = 285.000 + 332.500 = 617.500 (487.500 + 130.000)
The Company that doesn't amortize has a higher cash-outflow (taxes and dividends).
So its RETAINED EARNINGS are also higher than of the other Company by (70.000 = 332.500-262.500)

70.000 = 200.000 – 130.000 higher cash-outflow due to higher payment in taxes and dividends
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 Internal Financial Sources

Kinds of Depreciation:
- Functional (use).
- Physical (time).

- Economic (obsolescense).
- Technological.
- Changes in Product Demand.
- Changes in Remuneration of Factors

- Depletion.

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 14

 Internal Financial Sources
Depreciation as an internal financial source:
We are setting up a company.
This company is devoted to the transportation of goods and
so we bought a truck. We paid it cash and the cost was
100.000€
Equity = 120.000€

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 15

 Internal Financial Sources
Depreciation as an internal financial source:
We are setting up a company.
This company is devoted to the transportation of goods and
so we have to buy a truck. We pay it cash and the cost
is100.000€
Equity = 120.000€

We decide not to practice depreciation.

Pay-out policy = 100%

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 Internal Financial Sources: example

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 17

 Internal Financial Sources
Depreciation as an internal financial source:
We are setting up a company.
This company is devoted to the transportation of goods and
so we have to buy a truck. We pay it cash and the cost
is100.000€
Equity = 120.000€

We decide, YES, to practice depreciation

Pay-out policy = 100%

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 18

 Internal Financial Sources: example

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 19

 Internal Financial Sources: example

So, because of the depreciation expense, our company it’s been able to
retain some cash; enough cash to replace the truck at the end of its useful
life.

That’s why we say depreciation is a financial source.

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 20

 Internal Financial Sources

Financial Function of Depreciation:

During expanding periods:

Depreciation funds firms’ growth.

During stagnation or recession periods:

Depreciation funds debts repayment, or diversified
investment.

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 21

 Internal Financial Sources
• Accountants use depreciation as a way to allocate the costs of a fixed
asset over the period in which the asset is useable to the business.
• The bookkeeper records the full transaction when the asset is bought, but
the value of the asset is gradually reduced by subtracting a portion of that
value as a depreciation expense each year.

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 Internal Financial Sources
Secret reserve - Hidden reserve

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 Internal Financial Sources
• Hidden-reserves: Resource not listed on a balance sheet, such as land
or building shown at a value less than its market value. Sometimes hidden reserves are
deliberately (and illegally) created by undervaluing the assets or by overvaluing the
liabilities to show a lower taxable income.
• By undervaluing the current assets (market value)

• Secret reserve is also known as internal reserve. It is created by showing the figure of net
profit less than actual. Its existence makes the financial position of the business better than
what the balance sheet is disclosing.

• A secret reserve is created in any of the following ways:

•
* By depreciating the fixed assets at excessively high rates.
* By eliminating the assets altogether from the books.
* By over-valuing the liabilities.
* By showing contingent liabilities as real assets.
* By creating excessive amount of reserve for future contingencies.
* By treating capital expenditure as revenue reserve.
* By ignoring accrued income or treating income as liability

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 Internal Financial Sources
The multiplier effect of self-financing

Debt to Equity ratio: D/E

Leverage Effect: ROE

CAPITAL
STRUCTURE
This Company financed its assets with 60% of debt This Company financed its assets with 40% of debt
– THE PIE
MODEL

Debt = D
Equity = E
40%
40%
Equity = E
Debt = D
60%
60%

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 25

 Internal Financial Sources
Considering the following capital structure, in the event of a
reserves increase by means of 100 € retained earnings, what is
the maximum debt increase allowed to keep the original D/E
ratio?
Equity common
stocks 200 €
Reserves
ASSETS 200 € + 100 €
1000 €
+100 + ?
DEBT 600 € +?

Galeeva,G,, Sebastián, A., Solé, E. de Andrés, F. FINANCIAL MANAGEMENT 26

 The DuPont Model
Donaldson Brown (1920’s)

ROE = ROA x Leverage

Net profit / S. Equity = Net profit / Total Assets x Total Assets / S. Equity

Leverage is the equity multiplier: Total Assets = S. Equity x Leverage

ROA = Profit margin x Asset turnover

Net profit / Total Assets = Net profit / Net revenues x Net revenues /
Total Assets

D/E = Total Liabilities / S. Equity (Capital Structure and leverage of the company)

Leverage = D/E + 1 (Leverage = TA/SE, as TA=TL+SE, then TL+SE/SE = TL/SE + 1)

D/E = Leverage - 1

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 Capital Structure and Leverage

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