A Guide To Internal And External Sources Of Finance

From short term cash flow to larger investments, when you need extra capital for your business you have the option of internal and external sources. To help you make sense of which is right for you, here is a brief guide to internal and external sources of finance, what they entail and how they compare.

What are internal sources of finance?

Internal sources of finance come from within your business and are fully under your control.

Internal sources of finance examples

The main internal sources of finance are retained profits, asset monetisation and owner financing.

Retained profits: Retained profits are profits that are kept for your business’s own use rather than paid out to the directors or shareholders.

Asset monetisation: Asset monetisation is using business assets to generate funds. This can mean selling or leasing them. For example, a business may sub-let some of its real estate, or sell a piece of equipment to fund a new upgrade. 

Owner financing: Owner financing is money contributed from the personal finances of the owner(s) of the business. It may be provided as a loan or a gift. The fact that the lender is the business owner should, however, mean that the lender’s interests are in alignment with the business’s interests.

Internal sources of finance advantages and disadvantages

Advantages:

• Business are guaranteed to be eligible 

• Is convenient and easy to procure 

• Monetising assets allows a business to get extra value from something it needs (or needed) anyway

Disadvantages:

• Ties up funds that could be used in other ways

• Can prevent owners taking full advantage of their business assets

• Involves giving up use of a particular asset 

• Mixes personal and business finances

What are external sources of finance?

External sources of finance are provided by people or organisations outside of the business, such as online lenders or banks. 

External sources of finance examples

External sources of finance can generally be categorised into three main groups. They are equity investment, credit and grants or gifts.

Equity investment

Equity investment is where an individual or company puts money into the business in exchange for shares. The money does not need to repaid. This is typically used when the business expects to grow, so they get the capital to invest, and the investors can make a return as their shares increase in value.

Equity investment can come from crowdfunding, angel investors, friends, entrepreneurs, or investment firms. 

Credit

Credit is where you borrow money from an organisation or individual that needs to be repaid. There are numerous commercial financing products for businesses, including:

* Business overdrafts

* Business lines of credit

* Business credit cards

* Business loans (secured and unsecured)

* Business asset financing (secured and unsecured)

* Trade credit

* Business cash advances

* Invoice financing

Grants/gifts

Grants and gifts are arguably the best sources of external financing available since they do not need to be repaid and do not require you to give up any equity. Unfortunately, they also tend to be the scarcest sources of funding available. 

There are a multitude of government and local government grants, investment funds, innovation prizes and more that businesses can apply for. You can also run crowdfunding campaigns where you offer your product or service to those who contribute.

External sources of finance advantages and disadvantages

The main advantage of all external sources of finance is that it can help your business go further and faster than it could with internal resources alone. The common disadvantages are the cost or credit, the time it takes to apply and the eligibility criteria.

With equity investment, you can get capital with limited trading history and before you’ve built up your credit rating. The investors will often use their connection to support your growth, or in the case of crowdfunding you can create a loyal base of advocates.

The downside is that you give up shares in your business, meaning you take lower profits home. They may also demand a say in business decisions, giving you less control. 

With business credit, you get to keep all your equity and total control. However, applying for some products can take time, and interest costs and fees can impact your cash flow. You also need to stay up to date with repayments or you can face penalties or risk defaulting.

With grants and gifts, there is no cost of capital, or even need to repay the funds. There are, however, likely to be tight eligibility criteria or competition for the funds.

Internal and external sources of finance compared

In short, internal finance is relatively easy to obtain and there is no direct cost of capital. Generally, however, there is a limit to how much internal capital a business can raise, especially in the short term.  

Selling assets may bring a cash injection but it also means that the business ceases to have ownership of the assets. 

External finance can be harder to obtain and be more expensive. However, it can help you raise more funds to really drive your growth, and with the right terms can be affordable and work for your business needs. 

Options at Funding Circle

At Funding Circle we offer a variety of products to suit different needs, from business loans to short term lending.

Funding Circle business loans

Borrow from £10,000 to £500,000 over up to 6 years. All loans are fixed rate and come with no early settlement fees. 

Asset finance

Borrow up to £5 million to fund new equipment, vehicles, machinery or other assets through our partners.

FlexiPay

Spread the cost of business bills, invoices and more over 3 months with an interest-free line of credit of up to £250,000.