Internal Sources of Finance

Difference between internal and external sources of finance

There are two categories of sources of finance, internal and external. Which one do you think comes from inside the business? If you said internal, you're right. Outside? External is correct.

Whereas internal sources of finance include money raised internally, i.e. by the business or its owners, they do not include funds that are raised externally, i.e. by external parties such as banks, new shareholders, suppliers, government, friends, family, etc.

Types of internal sources of finance

There are several types of internal sources of finance a business can raise. They can be raised by the business itself or by its owners. There are three common types of internal sources of finance:

• Owner's funds
• Retained profits
• Selling unwanted assets

Fig. 1 - Types of internal sources of finance

Owners’ funds

Owners can use their own money to cover business expenses and invest in the business. Owners’ funds are money that entrepreneurs bring into the business. These funds typically originate from their personal savings, but they can also be earned by the owners, who are sometimes employed elsewhere.

Owners’ funds are a cheap, quick, and easy source of finance. As there is no interest, this source of finance is the least expensive. It is also easy to raise, as it can be arranged immediately. However, using owners’ funds as a source of finance is not always possible, as entrepreneurs might not have enough money to bring into the business.

This source of finance is very often used by new businesses. The reason for this is that when planning to set up a business, entrepreneurs typically save money to invest in it.

Owner's funds advantages and disadvantages

Retained profits

Businesses can also use the money they generate. Retained profits refer to a portion of a company's earnings that is kept within the business rather than being distributed to shareholders as dividends.

By investing retained profits, the company increases the overall company's value, but it might also not satisfy shareholders who were counting on getting dividends.

Retained profit advantages and disadvantages

Selling unwanted assets

To raise money internally, businesses can also sell some of their assets to make money from items they no longer needs for its daily operations. These may include additional vehicles, equipment, and machinery.

As there are no interest rates, this is a relatively cheap method to raise finance. However, it is only possible for businesses that have suitable assets.

Advantages and disadvantages of internal sources of finance

Using internal sources of finance has benefits (see Figure 2) and limitations. Let's take a closer look.

Internal sources of finance: advantages

• Low cost. As you might have noticed, none of the internal sources of finance involves costs such as interest rates or other fees. This is because by taking money from itself, a business will not have to pay additional fees.

• Maintaining ownership. By sourcing finance from itself, a business does not allow external parties to control it and take over the ownership. In doing so, it retains both control and ownership.

• Immediate availability (no approvals needed). When a business sources finance from itself, it does not need to ask anyone to approve it. It can raise funds whenever needed without asking for permission.

• No legal obligations. By raising money internally, the business is not legally obligated to pay anyone back. In fact, it does not have to pay back any money at all. This is because there are no contracts or third parties involved in the financing.

Internal sources of finance: disadvantages

• Limited funds: When a business sources finance from itself, it can only take the amount of money it possesses. It cannot rise any more because it simply does not have it.

• Decreased earnings: using internal sources of finances reduces earning available to owners and shareholders

• Reduced liquidity: it limits the amount of money that company has on hand which can make it more difficult to pay bills or suppliers.

As you can see, businesses can raise money without involving any other parties. They do it by using owners’ funds, retained profits, or selling unwanted assets. All of these methods have advantages and disadvantages that have to be considered carefully in order to raise a sufficient amount of money on time.

Internal sources of finance examples

It's time to take a look at how real companies use internal sources of finances:

• Apple Inc. has a history of retaining large portions of its earnings to finance new products and investments.
• General Motors had to sell its properties and other assets to reduce debt and generate extra cash. It allowed them to increase financial flexibility and invest strategically to improve their competitiveness.
• Facebook co-founder Mark Zuckerberg used his personal savings to fund the company in the early stages of its development.