Differences Between Internal and External Financing
To perpetuate, a business needs funding. It can be from its resources, or it can be sourced from somewhere else. When a company sources the funding from its sources, i.e., its assets, from its profits, we would call it an internal source of financing. On the other hand, when a company needs enormous money, and only internal sources are not enough, they take loans from banks or other financial institutions.
If we make a quick comparison between these two, we would see that the importance of both of them is similar. However, a company would get greater leverage (and save on taxes) if it takes debt from outside.
In this article, we will talk about both of these sources of finance and do a comparative analysis of internal and external financing sources.
Table of contents
Let’s get started.
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Source: Internal vs External Financing | Top 7 Differences (Infographics) (wallstreetmojo.com)
Internal vs. External Financing Infographics
There are a few differences between internal vs. external financing. Here’s the snapshot below –
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Source: Internal vs External Financing | Top 7 Differences (Infographics) (wallstreetmojo.com)
Internal vs. External Financing Differences
Here are the key differences between internal financing and external financing –
- Internal sources of financeInternal Sources Of FinanceInternal Sources of Finance are the income sources that a Company generates from within itself to cover its operating expenses or accumulate cash for investment & growth. These include Sales-generated revenue, Retained Profits, & Controlling/Reduction of working capital. read more are sources inside the business On the other hand, external sources of financeExternal Sources Of FinanceAn external source of finance is the one where the finance comes from outside the organization and is generally bifurcated into different categories where first is long-term, being shares, debentures, grants, bank loans; second is short term, being leasing, hire purchase; and the short-term, including bank overdraft, debt factoring.read more are sources outside the business.
- Companies look for funding internally when the fund requirement is quite low. In this case, external sources of financing the fund requirement are usually quite huge.
- When a company sources the funding internally, the cost of capital is pretty low. In the case of external sources of financing, the cost of capital is medium to high.
- Internal sources of funding don’t require any collateral. But external sources of funding require collateral (or transfer of ownership).
- Popular examples of internal sources of financing are profits, retained earnings, etc. Popular examples of external financing are equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more, debt financing, term loan financing, etc.
Comparison between Internal and External Financing (Table)
| The basis for Comparison – external vs. internal financing | Internal Financing | External Financing |
| 1. Inherent meaning | Finance is generated within the business. | The finance is sourced from outside of the business. |
| 2. Application | Internal sources are used when the requirement of funding is limited. | External sources are used when the requirement of funding is huge. |
| 3. Cost of Capital | Pretty low. | Medium to pretty high. |
| 4. Why? | The idea is to limit the business within a boundary (maybe not to grow so big). | The idea is to expand from local to national to global. |
| 5. Amount sourced | Low to medium. | Medium to huge. |
| 6. Collateral | No collateral is required. | Most of the time, collateral is required (especially when the amount is huge). |
| 7. Examples | Retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more, reserves, profits, assets of the company; | Equity financing, debt financing, etc.; |
Conclusion
Internal and external sources of finance are both critical, but the companies should know where to use what.
The right approach uses the right proportion of internal and external financing. If the company funds too much from its resources, it would be difficult for the company to expand the business. At the same time, if the company depends too much on external sources of finance, then the cost of capital would be huge. So, the company needs to know how to fund its immediate or long-term requirements.
Internal vs. External Financing Video
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