Difference Between Internal and External Sources of Finance

Business involves the commercial activity of producing and distributing goods and services to end consumers for profit. To carry out various business operations, an entity requires financial resources, making finance crucial for the sustenance of business activities. While the capital initially invested by the proprietor may not suffice to meet all financial needs, alternative methods are sought to fulfill both fixed and working capital requirements. These methods are categorized into internal and external sources based on their origin. Internal sources refer to funds generated within the business, whereas external sources encompass funds obtained from outside entities such as investors and lending institutions.

Different sources of finance offer unique characteristics, and it is essential to comprehend these traits to identify the most suitable source for meeting financial needs. This article will delve into the distinctions between internal and external sources of finance.

Internal Source of Finance

Internal sources of finance in business refer to funds obtained from existing assets and daily operations of the company. The objective is to enhance the cash flow generated from regular business activities. This involves assessing and managing costs, reviewing the budget, and ensuring efficient management of customer credit terms to optimize receivables collection.

Examples of internal sources of finance include selling surplus inventories, reinvesting profits back into the business, expediting the collection of receivables, and similar methods.

Example of Internal Source of Finance

One prevalent example of internal financing is the sale of stock, which represents the core aspect of a business where products or services are exchanged for payment. Similarly, debt collection is considered a form of internal financing involving the retrieval of money owed for previously supplied products or services, albeit with a potential delay between provision and payment. Additionally, the sale of fixed assets owned by the business serves as another important form of internal financing, particularly useful when additional funds are required to support daily sales operations.

Pros and Cons of Internal Source of Finance

Pros

• Internal sources of financing offer significant advantages for businesses. One key benefit is their accessibility, as these sources can be tapped into without encountering delays in approvals or dealing with extensive formal paperwork.
• Internal financing sources tend to be cost-effective, as businesses do not incur interest charges when utilizing them.
• Another advantage is that internal sources of financing do not require collateral, eliminating the need for businesses to pledge assets and thereby reducing solvency risks.
• Unlike external sources, internal financing options also do not entail covenants, meaning businesses can avoid restrictions imposed by lenders and creditors.

Cons

• A common drawback associated with internal sources of financing is their availability, which may not always align with a business's needs.
• For instance, while a business may generate profits, it may lack liquidity, hindering its ability to utilize retained earnings when necessary.
• Additionally, utilizing internal financing sources entails opportunity costs, as these funds could potentially be allocated to alternative uses within the business.
• For example, profits could be distributed as dividends to shareholders or retained for internal financing needs.
• Furthermore, the utilization of internal financing sources may not necessarily be well-received by shareholders and lenders. Balancing the management of both internal and external financing can pose challenges for businesses, as it may be difficult to satisfy the expectations and preferences of both stakeholders simultaneously.

External Source of Finance

External sources of finance pertain to funds obtained from sources external to the organization, whether from private individuals or the financial market. In external financing, funds are acquired from sources beyond the business itself. These external sources of finance are categorized into two types: long-term and short-term sources. Additionally, based on their nature, they can be further classified.

Debt Financing:- Debt financing involves obtaining funds where fixed payments are required to be made to the lenders. This encompasses:

• Bank loans
• Corporate Bonds
• Leasing
• Commercial Paper
• Trade Credit
• Debentures

Equity Financing:- Equity serves as the primary source of finance for many companies, representing ownership stakes in the firm and reflecting the interests of shareholders. Companies raise capital by selling shares to investors. This comprises:

• Ordinary shares
• Preference shares

Example of External Source of Finance

A frequently encountered external source of finance is a line of credit or a loan acquired from a bank. These are commonly utilized by startups to inject initial cash into the business, though they may also be utilized at various stages of the business's development. Another prevalent example of external financing is the issuance of shares in the business, which attracts investors to invest capital into the business.

Pros and Cons of Internal Sources of Finance

Pros

• External financing is a formal and widely adopted method of funding for businesses, providing access to capital resources on a formal basis whenever needed.
• External financing offers a broader range of options compared to internal sources. Equity, debt, and hybrid instruments are readily accessible to businesses seeking external funding.
• In addition to providing capital, external financing offers various other benefits. For example, once a business becomes publicly traded, it gains enhanced access to the capital market.
• Businesses utilizing debt and hybrid instruments also have the opportunity to negotiate terms and borrowing costs. Typically, as a business's credit ratings improve, its borrowing costs tend to decrease.
• Many external financing instruments are marketable securities, making them attractive to investors and creditors. Consequently, there is often greater interest in these instruments compared to internal sources of financing.

Cons

• External financing options tend to be more expensive than internal financing, as they typically involve interest charges on borrowed funds.
• Additionally, most forms of external financing necessitate collateral from the business, with debt and hybrid securities commonly requiring assets to be pledged to the lender.
• Moreover, external financing sources often impose debt covenants, which are restrictions placed by lenders on the borrower's use of profits and cash resources.
• In the event of default, serious consequences such as bankruptcy or legal actions may ensue for the borrower. Lenders also have the right to seize the pledged assets if the borrower fails to meet payment obligations.

Difference Table

Conclusion

Internal and external sources of finance play vital roles in business operations, but companies need to discern the appropriate circumstances for their utilization. An effective strategy entails striking a balance between internal and external financing. Relying excessively on internal resources may impede the company's ability to expand its business ventures. Conversely, an overreliance on external sources of finance can result in significant costs of capital. Therefore, companies must adeptly determine the optimal allocation of internal and external funding to address both immediate and long-term financial needs.