Internal and external sources of financing help businesses fulfill their capital requirements. Both types of financing offer discrete benefits and some limitations to the business.
Let us discuss what are external and internal sources of financing and their key differences.
What are Internal Sources of Financing?
Internal sources of financing are the financial sources of a business that can provide capital using internal sources of the business.
In simple words, internal financing sources are generated or earned resources without relying on “borrowing” externally.
Internal sources can be through profits, retained earnings, reduction in costs, or sale of assets to name a few. All of these sources are managed by a business without seeking any input from external stakeholders.
Types of Internal Sources of Financing
Here are a few common and most widely used internal sources of financing in a business.
Current profits are readily available sources of financing for a business. When a business generates profits, it can be used to fund business capital requirements.
However, profits are different from liquidity. A business showing profitability may not be able to utilize these funds if there is no cash available.
Retained earnings of a business are simply accumulated profits over the years. Retained earnings are the most valuable internal source of financing for any business.
Retained earnings provide immediate access to capital for a business. Moreover, utilizing this internal source of financing does not incur interest costs.
Sale of Products/Services
Capital generated through the sale of products or services is another primary source of financing for a business.
It is also a readily available source of capital for any business. Even if a business does not generate profits in the short term, it can utilize cash proceeds from daily sales.
The only drawback here is the risk of liquidity problems if a business does not generate sufficient cash sales.
Sale of Assets
The sale of assets is an indirect internal source of financing. If a business cannot generate sufficient profits or does not have retained earnings, it can sell one of the fixed assets owned by the business.
Usually, a business would sell fixed assets to provide capital funding for other requirements.
Pros and Cons of Internal Sources of Financing
Internal sources of financing have several advantages as compared to external sources.
The biggest advantage of internal sources of financing is their easy access. These sources can be utilized by a business without any delay in approvals and formal paperwork.
Internal financing sources are also cheaper. A business does not need to pay interest charges for utilizing internal financing.
Utilizing internal sources does not require any collateral. It means a business does not need a pledge. Therefore, these sources do not come with solvency risks for a business.
Unlike external sources, these financing sources do not come with covenants. A business may face restrictions from lenders and creditors when utilizing external financing.
A common drawback of internal sources of financing is their availability. Internal sources may not be available for a business when needed.
For instance, a business may generate sufficient profits but does not maintain liquidity. Therefore, it may not able to utilize retained earnings.
Also, utilizing internal financing sources always come with opportunity costs. It means there is always an alternative use for these sources for a business.
For example, a business can distribute profits as dividends or use them for internal financing needs.
Utilizing internal financing sources may not please shareholders and lenders as well. It would be hard for any business to manage both types of financing at the same time.
What are External Sources of Financing?
These are financing sources provided by external stakeholders of a business. Most common debt and equity financing sources are external.
External financing can be in the form of debt or equity. Both types of capital are linked to external stakeholders of a business.
External financing can further be divided into short-term and long-term financing sources. These sources are more costly than internal sources and come with a formal structure.
Types of External Sources of Financing
Let us discuss a few common types of external financing sources.
Equity – Common and Preferred Stocks
Shareholders are prime capital providers of any business. A business can receive capital through the issuance of stocks.
A business can issue common or preferred stocks. Both types of stocks come with discrete benefits and some limitations.
Equity financing is more costly than debt financing options though. Also, preferred shares would require dividends and a higher rate of return than common stocks.
These are debt instruments that can be converted into equity at maturity. Therefore, these sources are a hybrid form of debt and equity.
Convertible debt is a useful external financing source that is often used by publicly listed companies. The cost of convertible debt largely depends on the credit rating of the borrower.
Debt financing is the most common and widely used form of external financing. It is cheaper than equity financing.
Debt financing includes short-term commercial loans, lines of credit, and long-term loans. Debt can be in the form of bank loans or bonds.
In most cases, debt financing requires collateral. However, unsecured debt financing is also an option for businesses but is risky and more costly than secured debt financing.
Businesses can use some other forms of debt and equity financing that we can classify as external sources as well.
Venture capital and investments from business angels are common external financing sources. Similarly, day loans and other private lending sources are also examples of external financing.
Private equity or informal loans like loans from friends and family are also external financing sources.
Pros and Cons of External Sources of Financing
External financing sources have their pros and cons as compared to internal financing.
External financing is formal and most commonly used form of financing. A business can access external financing formally at any time.
There are more choices in external financing than internal sources. Equity, debt, and hybrid instruments are available for businesses easily.
External sources bring other benefits along with capital resources as well. For instance, once a business goes public, it enjoys greater access to the capital market.
A business using debt and hybrid instruments can negotiate the terms and cost of borrowing as well. In practice, as the credit ratings of a business improve, its cost of borrowing decreases.
Many external financing instruments are marketable securities. Therefore, investors and creditors have more interest in these instruments as compared to internal sources.
External financing sources are more costly than internal financing. These sources always incur interest charges on borrowed money.
Most types of external financing require collateral in some form from the business. Debt and hybrid securities almost always require some kind of assets to be pledged with the lender.
External financing sources also come with debt covenants. It means lenders put restrictions on the use of profits and cash resources of the borrower.
A default may result in bankruptcy or other legal consequences for the borrower. Lenders would also claim the pledged assets if the borrower defaults on payments.
Internal Vs External Sources of Finance – Key Differences
Internal and external sources of finance have some advantages and disadvantages to each other. Both types of financing come with some key differences.
Let us summarize some of the top differences between the two types of financing here.
Internal sources are generated by a business utilizing its assets and internal resources. This source of capital is generated within the business.
External financing comes through external stakeholders, lenders, and creditors. These sources of capital come from the external resources of a business.
Common types of internal sources include:
- Profits and retained earnings of a business
- Sales revenue of a business
- Sale of fixed assets
Common types of external financing sources include:
- Common and preferred shares
- Bank loans and lines of credit
- Bonds, commercial papers, and commercial notes
- Venture capital and business angels
There is no formal cost of borrowing when a business uses its internal financing sources. The only cost here is the opportunity cost for the business.
External financing incurs interest costs. It is always more costly as compared to internal financing.
Internal financing can be used to meet the short-term capital requirements of a business. These are limited resources that can be used to meet operational expenses like working capital, wages, taxes, etc.
External financing can be used for any purpose. Most commonly, these sources are utilized when a business requires capital investment for projects, expansion, refinancing, purchase of fixed assets, and so on.
Internal financing offers limited availability. It largely depends on the success and accumulated profits of a business. Also, the amount available can be very low as compared to external sources.
External sources are available at any time. However, a borrower must fulfill certain conditions to successfully avail of external financing. The amount available can be high depending on the credit rating and other factors.
Internal financing does not require collateral. These are resources already available for a business and do not require any assets to be pledged. External financing sources almost always require collateral in some form. Debt and hybrid instruments require credit rating, collateral, and sources of income as surety for approvals.