Every business requires finances at every stage of its operations. Right from the start up stage to day to day operations to funding expansions, finances are required at each stage. Businesses have several sources from which these finances can be generated. The source of finance has to be decided taking into consideration several factors including quantum of finance, cost of finance, time frame for payback etc. Thus, it is necessary to understand the features of different sources of finance.
This article looks at meaning of and difference between two types of sources of finance – internal and external.
Definitions and explanations
Internal sources of finance:
These are funds that are generated internally from within the business organization. Typical examples of internal sources of finance include funds generated from business operations i.e. profit from sales, utilization of accumulated reserves and funds raised from sale of business assets.
The cost of raising these funds is generally a notional cost i.e., a lost opportunity cost of earning profits by investing those funds elsewhere. For example, cash profit generated by a business if alternatively deposited in the bank can earn interest which would be foregone for being used as a source of finance. As such they rarely require an actual outflow of cash.
Internal sources of finances are generally sought out by profit making entities that are generating enough surplus from their business operations. Internal sources are typically used for funding day to day operations of the business.
External sources of finance:
- Debt essentially means any kind of loan or borrowing. This can include loans from banks, financial institutions, public deposits, letter of credit etc.
- Equity means raising of capital by issue of shares to existing or new shareholders. These can be ordinary shares or preference shares.
External sources of funds involve incurring a cost of raising the funds. As these are raised from outside entities, they need to be compensated for providing funds. Debt funds carry interest as compensation. Equity funds on the other hands carry dividend as compensation.
External sources of funds are preferred when large sums of money have to be raised especially for funding expansion plans. Loss making companies may also have to rely on external sources of finance to fund their day to day operations.
Difference between internal and external sources of finance:
The points of difference between internal and external sources of finance have been listed below:
- Internal sources of finance represent means of generating funds by the business itself from its own operations.
- External sources of funds represents means of generating funds through outside entities.
- Internal sources of funds lie within the organization.
- External sources of funds lie outside the organization.
- Examples of internal sources of finance include profits arisen from business operations, funds generated from sale of assets of the business.
- Examples of external sources of finance include debt funds such as loans, advances, deposits taken and equity funds such as equity and preference share capital.
4. Cost of finance
- The cost of internal sources of finance is much lower than external sources of finance. In fact, the cost is more in the nature of an opportunity cost foregone rather than an actual cost outflow.
- The cost of external sources of finance has to be paid to outside entities and is thus much higher.
5. Quantum of finance
- Generally lower amounts can be generated through internal sources of finance. The quantum depends on the profitability of the entity.
- Considerably higher amounts can be generated through external sources of finance.
6. Security required
- Internal sources do not require the presence of any security or collateral.
- External sources may require attachment of security as a guarantee for repayment.
7. Used for
- Internal sources are generally used for funding day to day business operations. High-profit making entities can however use these for growth plans as well if the funds generated are sufficient.
- External sources are generally used for setting up a business or at later stages for growth and expansion, when funds generated from internal operations do not suffice. Loss making companies may also use these sources for business revival or to keep their operations going.
8. Process for obtaining
- Raising funds from internal sources generally do not involve any formal process. It is a more automatic process where funds generated from business operations are re-applied in the business.
- Raising funds from external involves a more structured and formal process. This includes deliberation of the management,director and shareholder resolutions, holding meetings with financers, discussing terms and finalizing documentation
9. Parties involved
- Raising funds through internal sources generally does not involve any third party except where business assets are sold to generate funds.
- Raising funds through external sources necessarily involves one or more external third parties.
10. Tax benefits
- Internal sources of finance do not have any specific tax benefits.
- External sources of finance may involve incurring of tax-deductible financing costs such as interest. This can help reduce tax incidence on profits of the entity.
Conclusion – internal vs external sources of finance
The choice of source of finance depends on several parameters. Probably the first and foremost, being the quantum of finance required. Where sufficient funds can be generated through internal sources, entities may prefer it as it is simpler and generally less expensive than seeking external sources. However, where these funds are not sufficient for the business requirements, businesses have to turn to outside entities to raise funds.Tax considerations may also make entities choose between internal and external sources of finance.