Self-capitalization is a way of increasing the company's resources with its own funds. At the same time, greater third-party financing is avoided.
As a consequence of this policy, the company's capital stock will increase and the level of indebtedness will be reduced.
The two specific actions that are part of self-capitalization are:
- Minimum distribution of dividends: This means that the company will not distribute the benefits obtained, but that these will accumulate in the capital stock.
To put it another way, it is as if the owners of the organization agreed to reinvest the profits. Thus, they may allocate the profits of the last fiscal year, for example, to the acquisition of new machinery or to the implementation of a business expansion plan. By making this decision, shareholders are giving up higher income in the short term.
- Minimum indebtedness policies: The firm will try not to request further financing from third parties, that is, from the bank. The main advantage of this is that financial expenses (interest payments) will not increase.
However, we must take into account that, the higher the interest generated, the lower the net profit before taxes. So the pending taxes are lower.
In conclusion, a higher level of indebtedness could mean less effective outflows of money (and vice versa) for taxes.
It is worth mentioning that both actions of self-capitalization described can be taken together or only one of them.
Example of self-capitalization
A company makes a net profit in the last fiscal year, for example, of US $ 1,000. Unlike previous periods, the directors decide that no dividends will be distributed.
Thus, the proceeds are used for the acquisition of machinery for US $ 500 and the rest is accumulated in the capital stock of the firm, that is, in equity.