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External v Internal Finance Sources

external v internal finance sources

Every business needs money to operate and this can come from both external and internal finance sources. Whether it’s for day-to-day operations, business expansion efforts, recruitment drives or developing new products and facilities, every business owner must understand how to keep the business running with both internal financing from within the business and external financing from funders outside of the business.

Internal financing options include retained earnings, sale of assets and owner funding. External financing options include bank loans, equity Investment and crowdfunding.

Read on for an overview of external and internal finance sources, how to find the right balance between the two and the pros and cons of each route for business financing needs.

What Is Internal Financing and When To Use It

Internal financing comes from capital and funding that is generated from within a business relying on internal cash flows and assets over external sources. Examples include retained earnings, sale of assets and owner’s funds.

It can make strategic business sense to use internal financing during the early stages of business when there are small funding needs and short-term needs.

When a business is just getting started, it’s usually funded by internal financing until it can prove itself as a viable business venture and can attract external investment. Plenty of business needs require small amounts of additional funding that wouldn’t be worth the application process and administration work involved in seeking external input.

Examples include redecoration or building works. These would commonly be covered by business leadership but may require them to make an additional cash input into the business if existing funds aren’t enough to cover the value of the work required.

It’s also a great option when external finance sources are unavailable or risky – such as when the business doesn’t qualify for bank loans or has poor credit history. Business owners who don’t want to give up control of their assets or power to external financiers will also prefer this route.

Internal financing is usually only limited by its availability. If the business doesn’t keep a large amount of retained profit, assets available to sell or have ownership with unlimited personal wealth to inject, then internal financing is capped at what is available, but it will usually be the preferred method for most companies to finance their business with.

Internal Financing Options Pros and Cons

  • Retained earnings
  • Sale of Assets
  • Owners funds

Retained Earnings

Retained earnings refer to the net profit available to the company that is kept in the business rather than distributed to shareholders. This pool of cash accumulates ready to be used for future capital investments and business expansions without the need to bring in external finance.

Pros

  • Easily Accessible Capital – The funds are already sitting on the balance sheet ready for deployment into growth initiatives or operating needs. Avoiding pitching to lenders or investors is beneficial.
  • No Financing Costs – Unlike debt financing, retaining earnings avoids interest payments flowing out of the organisation to lenders or bondholders.
  • Preserves Control – Relying on internal equity financing rather than external equity issuances prevents ownership stake dilution and loss of decision-making autonomy.

Cons

  • Limited Availability – The pool starts small for early-stage startups not yet profitable and is capped even for mature companies by annual profit levels. Large needs may exceed retained earnings.
  • Foregoes Other Uses – Retained capital cannot also be deployed in alternative ways like paying dividends, paying down debt early, or repurchasing company shares.

Retained earnings is the optimal form of financing for businesses but it can take time to get to this stage and is fully dependent on business success.

Sale of Assets

Businesses have plenty of assets that can be sold to raise cash. This could be property, equipment, inventory or anything else owned by the company that could attract a monetary value through sale. The money raised can then be reinvested into the business where it’s needed.

Common categories of business assets that can be sold include:

  • Property – Land, buildings, facilities, real estate
  • Equipment – Machinery, tools, servers, hardware assets
  • Excess Inventory – Raw materials, finished goods, components
  • Intellectual Property – Patents, trademarks, licences
  • Business Units – Selling divisions, product lines, brands

Pros

  • Rapid Cash Influx – Asset sales can monetise tangible assets quicker than waiting on financing applications. Great for time-sensitive needs.
  • Shed Excess Capacity – Opportunity to sell underutilised, outdated, or obsolete holdings dragging down operations.

Cons

  • Lost Income Potential – Selling cash-generating units risks losing their future revenue, cash flows, and lifespan value.
  • Impact on Operations – Even non-revenue assets like equipment often support business workflows so their sale causes disruption.

While easy access to large sums, selling fundamental operating assets is usually a one-time fix. Balance sheet contraction from lost holdings may also hinder obtaining external financing. Companies should target shedding non-essential assets with caution so as not to sabotage long-term income generation.

Owner’s Funds

When a business owner(s) inject their cash into the business, this is considered internal funding. This personal funding may come from shareholders, business owners, partners or other principal leadership members.

Examples of owners’ funding include bootstrapping from personal savings, taking on second mortgages to free up cash, putting up their assets as collateral, borrowing from friends and family and cashing in retirement savings.

Pros

  • Full Control Retention – Avoiding external capital prevents diluting decision-making ability via given lenders covenants or issuing shares lowering ownership stakes.
  • No Repayment Obligations – Owner funds act as permanent capital without required interest expenses or principal repayments like debt.

Cons

  • Personal Financial Risk – Ties the owner’s wealth and finances to the business, jeopardising their stability in cases of poor performance. Difficult to decouple risks.
  • Limited Capital – Completely dependent on the owner’s current wealth and access to credit. Personal contributions are unlikely to support rapid scaling.

Owner’s funds trade-off limited capacity for full control retention when self-financing is critical. But further expansion eventually necessitates tapping external sources.

What Is External Financing and When To Use It

External financing refers to when money is injected into the business from outside sources, usually a bank, lending institution or investor. If a company is experiencing rapid growth, has limited internal cash resources, needs to make a major purchase or is going through financial trouble, then external financing can be a great option.

When experiencing rapid growth, external cash input can provide access to much more capital than is available internally. If the business needs to make major purchases such as new premises, equipment or inventory that would cost more than the available internal funding then external loans can help to push these business decisions though.

The downside to external financing is that it usually comes with a cost attached – usually in the form of interest repayments. Most businesses will see this as a worthwhile move for overall business growth though.

External Financing Options Pros and Cons

  • Bank Loans
  • Equity Investment
  • Crowdfunding

Bank Loans

Bank loans offer debt financing available from banks and other lending institutions that can be used to help with business operations, expansion goals and other capital needs. Money can be borrowed from these sources and repaid over a set period with interest.

Common types of bank finance include: 

  • Term loans where a set amount of money is borrowed then a fixed repayment schedule is agreed upon to repay the full amount plus interest,
  • Lines of credit like business overdrafts can be used with pre-approved borrowing limits. This can be used on a flexible basis and is useful for cash flow fluctuations.
  • Equipment financing is often used for big purchases such as photocopiers, or speciality manufacturing equipment and allows the cost of big-ticket items to be spread over some time.
  • Small business loans especially focus on business lending and will have preferential/competitive interest rates.

The Pros and Cons of Bank Loans include: 

Pros

  • Access Significant Capital – Banks have more lending capacity than individual investors, with small business loans ranging from $50,000 up to $5 million+. Enables major growth moves.
  • Flexible Repayment Timeline – Term loans allow 2-7 year repayment schedules, meaning manageable monthly payments rather than a balloon repayment. Lines of credit offer flexible access.
  • Tax Deductible Interest – The interest expenses incurred on bank loans can directly reduce taxable income. This deduction does not apply to equity financing.

Cons

  • Repayment Burden – Monthly principal and interest payments owed regardless of cash on hand. This fixed obligation can strain finances.
  • Collateralisation of Assets – Banks often secure loans against tangible business assets, meaning these could be claimed in a worst-case default scenario.
  • Loss of Some Control – Loan agreements contain restrictive covenants on finances, operations, and other factors that restrict certain business decisions.

Equity Investment

Equity finance refers to capital that is raised by selling part of the ownership stake in a business to external investors. There is no requirement to repay the funds and the external investor benefits by sharing the future business profits and company value.

Common sources of equity financing include:

  • Angel Investors – Wealthy individuals who invest their capital in early-stage startups.
  • Venture Capital Firms – Professionally managed funds that invest in companies with high growth potential.
  • Private Equity Firms – Similar to VC firms but invest in more mature, established businesses instead of startups.
  • Crowdfunding Platforms – Companies sell equity stakes to many small investors through internet platforms.

Pros

  • No Repayment Requirements – Equity is permanent capital as long as investors retain shares, freeing cash flow.
  • Rapid Access to Capital – Can secure large investments from external sources faster than saving profits.
  • Investor Experience and Networks – Many investors also provide advice, mentorship, and industry connections along with their money.

Cons

  • Loss of Control and Ownership Stakes – Issuing more company shares dilutes founders’/executives’ ownership percentages and decision power.
  • Investors Claim Future Profits – By owning equity, external owners profit from future financial success.
  • Ongoing Reporting Requirements – Investors typically gain information rights to receive financial statements, budgets, forecasts and other updates.

This external financing source allows businesses to raise good amounts of cash based on the business’s future potential rather than its current profitability or assets.

Crowdfunding

Crowdfunding is gaining popularity all the time as a great way to raise money from a large pool of people. These tend to be regular public members rather than professional investors looking to make big profits. The idea is that many people offer small sums of money to combine with large amounts of cash needed. Social media, Kickstarter and SeedInvest are maintain crowdfunding platforms.

Pros

  • Tap a Wide Investor Pool – Businesses have the potential to reach millions of potential investors instead of accreditation-limited angel and VC networks.
  • Marketing Exposure – High visibility campaigns build brand awareness and customer enthusiasm even if fundraising minimums are not met.

Cons

  • Complex Regulations – Equity offerings must follow rules about maximum raises, investor eligibility, disclosures and more under Regulation Crowdfunding.
  • Still, Relinquish Ownership – Equity crowdfunding does sell stakes in your company even if contributing smaller individual investments.
  • Numerous Stakeholders – Managing thousands of shareholders during major business decisions can be unwieldy.

If your business can navigate the compliance requirements, crowdfunding opens access to capital from non-traditional sources based on social momentum for high-potential ventures.

In Summary

There are various external and internal finance sources available for businesses. To recap, internal finances look at options like existing company cash flow like retained earnings and owner cash available. Internal financing keeps control over the business but can sometimes be restricted in how much cash is available.

In contrast, external finance sources like bank debt, equity stakes and crowdfunding open up new streams of cash revenue but will often result in loss of partial ownership or higher expenses through loan repayments.

The best type of funding for a business will usually be a mix of both internal and external finance sources. The key is to understand the pros and cons of each before making any major financial decisions that can impact business growth positively and negatively.

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