Definition
Internal financing refers to the generation of capital by retaining the earnings or profits of an organization, or through reducing operational costs, essentially using resources within the business. On the other hand, external financing refers to acquiring capital from outside sources such as banks, investors, or issuing bonds or shares. Both methods serve the purpose of funding the operations, expansion or acquisitions of a business.
Key Takeaways
- Internal financing is the process of generating funds from within the business through means such as profits, depreciation provisions, reduction of working capital, sale of assets, etc. The main advantage of internal financing is the lack of interest or any borrowing costs. However, the major disadvantage is that over-reliance on internal financing might halt the further growth and expansion plans of the business.
- External financing involves generating funds from sources outside the company, such as loans, issuing shares or bonds, or acquiring funds from lenders or investors. External financing can aid in significant growth and expansion as it allows businesses to obtain large sums of money. The key disadvantage comes in terms of interest costs and potential dilution of control over the business.
- Businesses often need to balance internal and external methods to optimize their financing strategy. Using a combination of both types can help to handle different contingencies, while minimizing associated costs and risks. Decisions should be based on aspects like the nature of the business, market conditions, interest rates, business growth plans and the level of control they wish to maintain on the business activities.
Importance
The distinction between internal and external financing is crucial because it impacts a company’s strategy, flexibility, and control over its operations.
Internal financing, which includes profits reinvested in the business, allows a company to grow and develop using its own resources, helping avoid debt or equity dilution.
However, it can limit the firm’s growth potential if internal resources are scarce.
On the other hand, external financing, through debt, equity, or other funding sources, can provide a significant financial boost and facilitate rapid expansion, but it often comes with increased liabilities, potential shareholder dilution, and certain expectations from lenders or investors.
Hence understanding the balance between these two options is vital for businesses to manage their funds effectively, ensure sustainable growth, and meet their long-term financial objectives.
Explanation
Internal financing is a strategic method that involves a business utilizing its own profits or assets to generate growth or pay off debts, instead of seeking additional funding through external means such as loans or investors. This approach primarily serves to retain control of the business and avoid potential interest costs that come along with borrowing.
Moreover, it allows businesses to manage their growth at a sustainable pace as funding is dependent on the profits generated internally. A common form of internal financing includes reinvestment of profits back into the business for equipment upgrades, research and development, or expanding operations.
On the other hand, external financing involves procuring funds outside of the company through methods such as loans, issuing of debt or equity securities, or obtaining venture capital or angel investments. This form of financing is generally used when the potential growth of the business is believed to far exceed the capacity of internal funds, and thus external funds are required to capitalize on this opportunity.
With the external financing, businesses have the ability to achieve goals quicker due to immediate access to significant funds. However, it can potentially dilute ownership, involve repayment obligations, and require companies to disclose more information to lenders or investors.
Examples of Internal vs external financing
Small Business Funding: A bakery owner wants to open a second location, so they need additional capital. They could choose internal financing by reinvesting the profits from their existing business into the new location. Alternatively, they could seek external financing, such as taking out a business loan from a bank or attracting a new business partner who’s willing to invest their money into the project.
Household Financing: Consider a family planning to buy a new car. They could use internal financing by saving money from their monthly income until they have enough to pay for the vehicle. On the other hand, they might choose external financing by acquiring a car loan from a financial institution.
Corporate Expansion: A tech company could use internal financing for expanding their operations via accumulated retained earnings or decrease their working capital. This can be seen as safer because they don’t have to worry about paying interest or defaulting on a loan. However, if the expansion costs are significantly larger than their available funds, they might have to resort to external finance, like issuing new shares on the stock market, borrowing from banks, or issuing bonds.
FAQs about Internal vs External Financing
What is internal financing?
Internal financing is the process of allocating a company’s existing resources or earnings back into the business to fund its operations or expansions. Common sources of internal financing include retained earnings and depreciation reserves.
What is external financing?
External financing refers to any funding a company obtains from outside sources, such as banks, private equity firms, or public sources like issuing shares. This type of financing is usually sought when a company’s internal resources are insufficient to support its growth or operations.
What is the key difference between internal and external financing?
The key difference lies in the source of funds. Internal financing is generated from within the organisation e.g. from a business’s profits. In contrast, external financing involves obtaining funds from an outside source like a bank or equivalent financial institution.
What are the advantages of internal financing?
Internal financing is generally less risky as it doesn’t require taking on debt or diluting ownership through issuing more shares. It also gives a company more control over its finances and can be less expensive since there are no interest payments involved.
What are the disadvantages of internal financing?
One major disadvantage of internal financing is that it may not provide sufficient funds, particularly for large-scale expansions or investments. It may also lead to missed opportunities if earnings are reinvested back into the business instead of being used for other potentially profitable ventures.
What are the advantages of external financing?
External financing can provide significant resources for growth, particularly for start-ups and small businesses. It also can allow a company to take advantage of strategic opportunities quickly, without needing to generate surplus cash flow first.
What are the disadvantages of external financing?
External financing can be costly due to interest payments on debt or dividends on equity. It can also result in a loss of control if shares are issued, and it can place additional pressure on cash flow due to the obligation to service debt.
Related Entrepreneurship Terms
- Equity Financing
- Debt Financing
- Retained Earnings
- Trade Credit
- Public Offerings
Sources for More Information
- Investopedia: A comprehensive website often considered the ‘Wikipedia of Finance’, this source provides detailed articles about internal and external financing.
- The Balance: A personal finance website that covers everything from investment tutorials to tips on budgeting your money. It offers many articles and resources related to internal and external financing.
- Corporate Finance Institute: This educational organization offers professional courses and certifications in the field of corporate finance, with detailed material on internal and external finance.
- Khan Academy: This non-profit educational organization offers a plethora of online courses, including lessons on business financing which cover the topics of internal and external financing.
