All You Need to Know About Internal and External Sources of Finance
September 13th 2019 at 10:07am Published by sharpshooteradmin
Regardless of your industry and the scope of your operations, finance is believed to be the backbone of your business. Every business follows a model that is based on marketing and selling products and services. The model does include strategies on managing day-to-day operations, but it might not guide on how to obtain finance. After all, every business needs funds to manage their processes, avoid liquidity crunch, and maintain a positive net cash flow balance.
As a proprietor, you bring in a limited amount of capital into the business during the incorporation stage. The startup capital might be sufficient for running basic operations and core business processes for the time being, but it doesn’t facilitate growth and business development.
Thus, when it comes to expanding or increasing the scope of your business, you have to look around for various financing options.
While we will be discussing numerous options in this post, all of your choices fall under the broad categories:
- Internal financing
- External financing
Both these sources of finances help you acquire funds to finance the growth you have forecasted for your business. There are multiple options present within these two broad categories, and we will be discussing all of them with their relevant pros and cons.
When talking about internal sources of finance, you are dealing with the funds that your business currently has ownership over. In other words, these are your internally-generated funds. These funds could be in the form of emergency reserves or retained earnings.
In internal financing, you exhaust your current resources to finance a major decision that you are going to take within the near future. The sources you use depend on the type of financing you need.
We first discuss the general pros and cons of internal financing before heading out to the sources or options you have here.
Pros of Internal Financing
Organization Maintains Full Control
Perhaps the biggest reason for favoring internal financing is that it can help businesses in maintaining full control over their processes. If you have the resources available within the business, there is no need to look for external help, as you would lose a bit of your sovereignty or decision-making autonomy in the process.
Some external sources of finance can be hard to acquire, and they come with numerous strings attached to them. The funding party makes sure that the financed amount is being spent towards a specific category and not for any other motive. This check and balance can steal the autonomy of a business.
It has been proven to be true that firms go for better and more comprehensive planning when they are using the internal resources currently within their business. This planning comes to the picture because organizations realize this is their own money and they cannot spend on extraneous things, as they don’t have spare cash available with them at the given moment.
Reduces Overall Cost
Continuing on the point we have mentioned above, using internal sources of finance can reduce the overall cost that you spend on a particular project. Besides just the planning process, internal sources of finance can also help you save on costs that you will incur during repayment.
Let’s just imagine you need a new vehicle for your business. The vehicle is going to cost you roughly $20,000. If you are going to finance the move through internal sources of finance, you will just make the payment and finish the transaction. However, with external sources of finance, you have to look around for repayment plans and also incur the rates that are part of the process.
Limits Outside Influence
Going for internal sources of finance can limit the outside influence on your organization. Internal sources of finance are provided from inside the business, which means that the amount being invested is of the owner, and no third party has the right to interfere in the company’s processes. But with external financing or debt financing, you might see numerous stakeholders trying to dictate your processes and disrupting the natural process from happening.
Cons of Internal Financing
Just as we have discussed the advantages or pros of internal financing, we will now discuss the cons of this process:
Impacts Your Operating Budget Negatively
Since you’re expanding or making growth from the budget that is set for your business, the money needs to come from somewhere. For most businesses, this requires taking cash out from the operating budget or the capital they have set for themselves.
By depleting their cash reserves, businesses often take themselves into a complex situation, where there is no way out. Not many organizations use internal sources of finance for long term projects, because of this very reason. The immediate impact on the working capital or the operating budget is a bit too much to handle for most businesses.
Requires Accurate Estimates
You need to have reasonably accurate estimates and predictions for this method to work for you. If you have limited internal reserves, you should know the impact of working at a lesser operating capital on the longer run.
You must also estimate the time it will take for you to get back at the operating capital levels you had before you went on with this move. These estimates or predictions should be accurate. Otherwise, you will reach a complex crunch like situation.
Requires Spending Discipline
A lot of discipline is needed in spending if you are financing growth through internal means. One might think that this is a positive change, but let us warn you that discipline in spending can take a lot of time. Let’s say you need a developer for your AI growth move. The models are ready to develop, but you want to follow discipline in spending and the pay you give to your AI team. Now, you will take a lot more time hiring the right person, than you would have taken if you had the right reserves to pay the new team.
Internal Sources of Finance
Having studied the pros and cons of internal financing, we now move on to the options you have for financing when it comes to internal finance:
Almost all organizations retain some of their profits on a monthly or annual basis. These retained profits are deposited in a separate fund, which is used during times of emergency or when you need internal financing for a project.
Retained profits, if they are left to accumulate over a long term period can develop into a sizable amount and can be good for your financing project.
However, we believe that most companies almost always have something in mind for the retained profits they are saving up. Most managers or entrepreneurs aren’t okay with using retained profits if a sudden expense shows up or you need sudden financing. They want to use this reserve only for a specified purpose they have in mind, which could either be growth or survival.
Sale of Assets
Another internal source of finance which most organizations follow is the sale of an asset. This we believe is something that should only be followed during a do or die situation.
Your assets play a pivotal role in your production and operational processes. This is why you must realize the impact the sale of an asset could have on these processes.
Don’t make a hasty decision, as you don’t want to sell the wrong asset in your haste. However, this option can be best for businesses that have obsolete assets lying around unused. All such assets can be put to use for financing the business and making sure that you have the reserves for any short term or long term plan.
Reducing Working Capital
One step most businesses take as part of internal financing is to reduce their working capital. The working capital is usually the difference between your current assets and current liabilities and is used for financing the day to day operations of your business.
The amount for working capital determines the liquidity of your business, and you cannot risk a long term liquidity crunch for a short term gain. You need to evaluate your options properly, and only take this move if you are sure about how long it will take for you to get back to the same amount of working capital you had before this move.
Again, it is necessary here that you maintain discipline and accuracy with the predictions you make for your working capital. Your working capital is the oil that lubricates the engine of your business. Just like you cannot afford traveling on low engine oils for long, you shouldn’t underestimate the importance of your working capital as well.
Dealing with Cash Sales
This is usually a long term policy, but most business owners believe that they can generate sufficient long term funds by starting to deal in cash sales only. Credit sales take some time for actualization, and by dealing in cash sales only, businesses have a better working capital flow. The increase in working capital means that all businesses can now easily get the desired funds they want from their working capital.
This source of financing cannot work if you have a quick option to finance. It is only viable if you want to finance growth a month or two down the line, at least.
If we understand the intricacies of the language, we can get to understand that the term ‘external source of finance’ defines the very nature of capital. Capital is acquired through external means, and all the popular sources of finance including equity capital, debentures, small business funding, venture capital, leasing, trade credit, bank overdrafts, etc. are all external sources of finance.
To further explain the definition to you, external sources of finance are those sources of finance that are acquired from outside the business. For instance, retained earnings are present inside the business, so if you are using them, you are generating finance from inside. But with external sources of finance, you are using finance from outside the business to meet your objectives.
Before we head to the different sources of external finance, with their detailed description, we will first shed some light on the pros and cons of this financing option:
Pros of External Finance
No Loss of Control
The biggest myth associated with external sources of finance is that you’ll lose the control you have over your business. There is not much truth to this assumption, as much of the control will still lie in your court.
Neither will an external investor have a say in how your business operations are run, nor will they take away the control of your processes away from you. The way you manage your funds will ultimately depend on what you want to achieve. If you’re obtaining the funding for a specific purpose, then how you use the amount for meeting that specific purpose will stay lie in your court. All the opinions about you losing control are nothing but myths.
The presence of choice and multiple options can almost always make investors think judiciously. If you’re also thinking between internal and external sources of finance, then you might be tilted towards external sources because of the sheer presence of so many options. As we have already mentioned above with internal sources of finance, you don’t have as many options as you would want for investing in a future goal.
With external sources of finance, you get a lot more options, and these options help you in choosing the best option out of the lot.
Greater Access to Money
Small business funding and other sources of external finance can give you access to a greater amount of money. When it comes to internal sources of finance, your options are limited and you don’t have access to that much cash. With external sources of finance, you get a lot more money on your hands and can invest that money the way that you want to.
While you will have to pay the interest rates on the funding you take, we believe that the tax advantage you will get will almost always compensate for that funding payment. The interest you pay is often deductible on your taxes, leaving you with almost the same amount of profits.
Cons of External Financing
Perhaps the biggest disadvantage of external financing is that you will have to follow the strict guidelines laid down by your funder. Most businesses, when they go to for financing to banks, are greeted with a stringent list of details on how the repayment plan should work. Banks have their profits and annual reports to maintain, which is why they are extremely strict on repayment terms.
However, the more contemporary sources of finance such as private funders, allow you more relaxation on the payment terms you follow. They also allow you to pay the amount through a fixed deduction from all sales made on your credit card.
You’re never sure about the money you will have to pay for meeting the interest on your funding. Interest rates keep fluctuating, and you might have to pay more for the finance, then you first reckoned. The rates for small business funding provided by banks tend to be high in the first place, and they can fluctuate to create a big mess.
Almost all banks ask for collaterals before they can approve your funding. Collateral is a house or an asset that you can use to secure the funding. The collateral works as a form of security against your name. Businesses that don’t have collaterals cannot head over to banks and traditional financial institutions for funding.
However, you surely can get funding without securing collaterals, from private funders. Small business funding provided by these funders do not require you to submit collateral, as they review your process without the presence of one.
Strict Approval Rates
Banks are criticized by many for having strict approval rates. Most banks do not approve the requests for funding, because of the very reason that the request doesn’t match the standard they have. Banks follow a strict criterion when it comes to giving funding and they only approve funding requests that meet the criteria.
However, you can head over to a private funder here as well, as they don’t have strict approval rates and will approve your funding request regardless of your credit rating. However, they sure will set the interest rate based on the credit rating and credit history you have.
External Sources of Finance
There are multiple sources of external finance, which include:
The first source of external finance has to be bank funding. Bank funding is taken from a financial institute, most often a bank, for meeting a cash crunch or for financing a future growth move. Bank funding happen to have strict repayment schedules attached to them, and they are hard to get approved.
While this option might not be plausible for you as a small business owner, but you can always generate finance by selling equity shares in the market.
Money from equity shares is generated when you sell shares for ownership in your company within the market. These shares are either sold to private investors (such as your friends and family members or angel investors) or public investors within the stock exchange.
Once you get registered in the public stock exchange, a lot of things about your company will change. For starters, you won’t have the kind of autonomy you require in decision making anymore.
The shares you sell in the market are distributed into numerous categories. These categories include:
- Ordinary shares are shares you sell in the stock exchange at fixed rates. These shares are paid based on the revenue you make, and there is no fixed payment that you need to give to shareholders.
- Preference shares are also sold in the stock exchange, but here you will have to be a fixed share to your shareholders.
Shareholders are given a share of your profits in return for the investment they make in your business. Hence, besides sharing ownership, you will also be sharing profits with the shareholders you have now.
This is a short-term external finance option given by a bank. If you are a regular customer, your bank will give you overdraft facilities where you can take out more cash than what is present inside your bank account. Your bank balance will be negative when you do so, and the overdraft will be deducted from whatever sum is deposited into your bank account next. Banks often place limits on overdraft facilities, which is why you can only take the funding for a short period.
Short-Term Funding from Private Funders
Considering the strict regulations and approval rates of banks, many private funders have made their way into the market. These private funders do a good job at ensuring that all business owners can get their hands on small business funding. These traders follow a simple and quick approval process, by the end of which your funding will be transferred towards you.
The best part about such funding options is the convenient repayment plan. Private funders realize the hassle you will have to go through at the time of repayment, which is why they give you a convenient option for repayment.