Internal Sources of Finance

Intro: The advantages and disadvantages of internal sources of finance allow companies to retain
more control and limit their overall expenses. It also means there are fewer insights to gain and
added risks to the budget should something go wrong. In most cases, it is usually beneficial to
avoid debt. There are times when it may also be advantages to explore some limited external
debt. That is why all options should stay on the table while making a financing decision.

Advantages Disadvantages

1. It allows an organization to maintain full 1. It may have a negative impact on your

control. operating budget.

When you are using internal sources of
finance, then you do not have the same
repayment commitments as you would with
external debt. You don’t need to worry about
that payment schedule matching up with your
earnings schedule. Your main requirement is
to ensure a repayment happens at some point,
which means you can schedule your own
repayments when it makes financial sense to
do it.
Because you are using internal sources for
your funding needs, that money is going to
need to come from somewhere. For most
businesses, that means taking cash from their
capital or their operating budget. That means
you’ll have less money available to manage
the expenses which happen every day. For
that reason, most companies tend to use
internal sources of finance for short-term
projects only. That way, the budget receives a
payback as soon as possible.

2. It improves the planning process. 2. It requires accurate estimates to be

Firms tend to be more careful when planning
new projects when using internal financing
compared to external financing. There is no
illusion that you have cash to spare when
using internal sources of finance. You’re only
spending the money that your company has
earned or set aside for a project just like the
one being considered. That makes it less
likely that spending on extraneous things will
occur, which creates positive spending habits
over time.
effective.
If internal sources of finance are being used
for a project, then the cost estimates must be
reasonably accurate for this financing option
to be effective. You must be able to determine
the true costs of the work, and provide
accurate forecasts, to understand how the
investment will be recouped over time.
Accurate estimates are also required to be
able to calculate the anticipated return, which
is necessary for future budget planning needs.

3. It reduces the overall cost of most 3. It may have fewer tax benefits for the
projects. organization.
When you’re using external sources of
finance, then the lending generates interest
payments that can make borrowing expensive.
This happens on the individual level as well.
Imagine that you’re purchasing an asset that is
$21,000. If you use internal sources of finance
for the purchase, you pay the expense and that
completes the transaction. Then you can repay
the cost monthly, if needed, from other budget
lines. With external sources, at a 4% interest
rate over 6 years, you’d pay almost $10,000 in
interest that wouldn’t be required with
internal sources.
4. It improves the overall value of the
company.
Investors don’t like to see a lot of external
debt with a company. High debt levels
indicate more risk, which reduces the overall
value of the company. You’ll also see
improvements in the credit score of your
business if you are utilizing less debt too.
Internal financing resources may create
expenditures that may be difficult to manage
in the short-term sometimes, but from a
long-term perspective, managing debt levels
will always create long-term financial health
for most companies.
5. It limits outside influences on the
company.
If you involve people from outside the
company with your project, then you’re
ceding a certain level of influence to them
over the outcome desired. Even if your
external financing involves a bank which
wants nothing to do with the planning
When a firm uses external financing for their
projects, then the debt created may have
specific tax benefits which internal financing
is unable to provide. Although tax laws vary
throughout the world, and can change at any
time, most companies can take a tax
deduction in the interest they pay on external
debt. Depreciation of assets is available for
purchases as well. That means a company
with a high tax rate will often avoid internal
sources of finance whenever possible.
4. It requires spending discipline.
Just because you have internal money
available to you doesn’t mean you are
required to spend it. There must be high levels
of self-discipline within a company’s C-Suite
for internal financing to be effective. Without
strict monitoring of the budget, project costs,
and earnings, then it can be very easy for a
company to get into financial trouble. When
there are issues with internal sources of
financing, a company often looks toward
external debt to solve the issue. That creates
even more debt than would have been
necessary if external financing were used in
the first place.
5. It can take more time to complete
projects.
With external sources of finance, you are able
to obtain all the funds required for the project
immediately. That allows you to get started
right away, reducing the time commitments
involved. With internal sources of finance,
your access to funds can sometimes be
process, you must still prove to the lender that
your business plan is a low-risk opportunity to
create profits. You must show that you’ll have
the ability to repay the financing. That means
your decision is influenced by the need to
repay instead of the needs of your business at
the time.
6. It offers several sources for the cash that
you require.
There are several sources of internal financing
which may benefit a company over time. The
most common method is to use retained
earnings, as this does not create a dilution in
ownership or control. You can also use the
sale of assets to fund projects, which can
work for short-term or long-term needs. A
reduction in working capital is also possible,
which streamlines your operations while
reducing bank charges.
7. It requires no additional equity to be
issued.
Unless you take on debt, external financing
almost always requires additional equity in
the company to be issued. That means there is
dilution in the ownership structure of the
business. Internal sources of finance eliminate
this issue.
slower. You might be required to build up
funding levels before you can get the project
started. While you’re doing that, there is a risk
of missing new business opportunities
because the focus is on developing internal
financing instead.
6. It can cause some companies to starve
departments of cash.
Some companies will also end up devoting
too many of their financial resources to the
projects being considered with internal
financing. When that occurs, some areas of
the company may find themselves being
starved of cash. Without enough cash, even if
it is just in one department, it becomes more
difficult for the company to stay healthy.
7. It limits the number of outside insights
that are available.
Although there may be additional costs
associated with external sources of financing,
you’re able to glean insights from multiple
third parties when you decide to take on some
debt. Those insights can be extremely
valuable to the company, offsetting the
overall costs of using external financing
instead of internal financing. If you are taking
on a project which requires expertise you
don’t have internally, then internal sources of
finance are not usually a good option.

External sources of Finance:
Advantages
Advantage: Preserving Your Resources
One of the advantages of external funding is it
allows you to use internal financial resources
for other purposes. If you can find an
investment that has a higher interest rate than
the bank loan your company just secured, it
makes sense to preserve your own resources
and put your money into that investment,
using the external financing for business
operations. You can also set aside your
internal financial resources for cash payments
to vendors, which can help improve your
company's credit rating.
Advantage: Growth
Part of the reason organizations use external
8. It increases the risk of a bankruptcy for
some businesses.
If a company decides that a reduction in
working capital is the best source of internal
financing, then it will assume a higher risk of
bankruptcy. When working capital is at very
low levels, all it may take is one unexpected
expense to become the tipping point for
financial health. For that reason, even the sale
of certain assets may be a better option, even
if the useful life of the asset is still valuable
internally, because it does not impact the
bankruptcy risk as working capital reductions
do.
Disadvantages
Disadvantage: Ownership
Some sources of external financing, such as
investors and shareholders, require you to
give up a portion of the ownership in your
company in exchange for the funding. You
may get that large influx of cash you need to
launch your new product, but part of the
financing agreement is the investor is allowed
to vote on company decisions. This can
compromise the vision you originally had for
your company when you founded it.
Disadvantage: Interest
External funding sources require a return on
funding is it allows them to finance growth
projects the company could not fund on its
own. For example, if your business is growing
to the point that you need additional
manufacturing space to keep pace with
demand, external financing can help you get
the funding you need to build your addition.
External funding can also be used for making
large capital equipment purchases to facilitate
growth that the company cannot afford on its
own.
Advantage: Advice and Expertise
Organizations willing to finance your
business can often also be useful sources of
expert advice. Your banker, for example, has
funded many other small businesses and may
be able to offer guidance as to how to avoid
pitfalls that created problems for some. An
investor in your technology start-up likely has
technology expertise of his own to offer, and
even if not, may be able to steer you towards
useful sources of advice.
Bank Loan (Advantages)
Advantages
● Banks don't take an ownership
position in the business.
● There are no more obligations to
the lender once a loan has been
paid off
● Option of fixed rate loans, where
the interest rate doesn't change
for the life of the loan.
Business Angels (advantages)
their investment. Banks will add interest to a
business loan, and investors will ask for a rate
of return in the investment agreement. Interest
adds to the overall cost of the investment and
can make your external funding more of a
financial burden than you had originally
planned.
Disadvantage: It's a ​Lot​ of Work
Securing external funding can be a nearly
full-time job in its own right. You're faced
with the task of identifying potential sources
of funding, preparing a slick business plan,
practicing a presentation, and calling dozens
of people to arrange – or try to arrange – a
face-to-face meeting. All of these tasks take a
good deal of time and resources. None of
them are a guarantee that you'll get the funds
you're seeking.
Bank Loan (disadvantage)
● Difficult to obtain without a
substantial track record
● Possibility of seizure of personal
assets in some cases
● High-interest rates, sometimes
can't get enough funding to meet
business needs
Business Angels (disadvantages)
 ● Free to make fast investment
decisions
● No need for collateral
● Access to investor's knowledge
● No repayments or interest
Government Assistance (advantages)
● Can provide huge amounts of
investments
● Gives an organisation exposure
and credibility and public
exposure.
Issue Share Capital (advantages)
● helpful in raising long term
capital for the company
● enable the business to expand, or
invest in assets that will enable it
to grow in the future.
● ● Stockholders can block plans if
● The company does not need to
repay this share capital, but
instead agrees to distribute
future profits to stockholders in
return for their investment.
Mortgage (advantages)
● can keep ownership of business
and business premises. no
requirement to give up business
control or ownership.
● Takes longer to find a suitable
business angel investor
● Requires giving up a share of
your business
● Less structural support than
from an investing company
Government Assistance (disadvantages)
○ Very competitive and
hard to get
○ Must be spent
according to complex
regulations and laws
○ Often based on a
reimbursements
system
Issue Share Capital (disadvantage)
● Owners no longer have full
control of the business
● Business becomes
● accountable to stockholders
●
they believe they pose too great a
risk to their investment.
Mortgage (disadvantage)
● need a decent sized deposit. (money
which could be used for other
 ● can make substantial capital
gain
● tax deductible interest
repayments
● fixed interest options
● lower interest rates than
overdrafts
Leasing (advantages)
● lease startup costs are lower
Leasing (disadvantage)
than buying equipment/premises
upfront
● you can claim lease payments as
business expenses
● relocating from a leased
property can be easier than
depending on the sale of an
owned premise
Overdraft (advantages)
● flexible - an overdraft is there
when you need it, allows the
business to make essential
payments whilst chasing up your
own payments, helps maintain
cash-flow
● quick - overdrafts are easy and
quick to arrange, providing a
good cash-flow backup with
minimum fuss
Trade Credit (advantages)
purposes)
● harder to move business when
premises are owned rather than
leased
● variable rate mortgages are
vulnerable to mortgage rate
increases
● if the property loses value, capital
will be reduced
● more expensive that outright
purchase over the long term
● lessee never actually own the item
● rent money does not contribute to
business assets or capital growth
● you depend on the landlord for
maintenance
Overdraft (disadvantage)
● Cost - overdrafts carry interest fees,
at much higher rates than loans. -
expensive for long-term borrowing,
legal charges if overdraft limit is
exceeded
● Recall - the bank can recall an
overdraft at any time
● Security - overdrafts may need to be
secured against business assets,
which puts them at risk if
repayments aren't met
Trade Credit (disadvantage)
 ● reduced capital requirements
● improves cash flows
● businesses can buy now and pay
later, can pay for products after
they have been sold and profit
made
● business can focus on sales,
marketing and research
Venture Capital (advantages)
● Mentoring - venture capitalists
provide companies with ongoing
strategic, operational and
financial advice.
● Alliances - venture capitalists
can introduce the company to a
network of strategic partners
● Venture capitalists are
experienced at organising IPOs
1.
Bank Loan (Advantages)
Advantages
● Banks don't take an ownership position in the business.
● There are no more obligations to the lender once a loan has been paid off
● if repayments are not made by
deadlines, the business will receive a
poor credit history which will
severely damage the business's
ability to secure loans
● only companies with credit history
will get trade credit, this is
especially difficult for new
businesses
Venture Capital (disadvantage)
● pricing - venture capitalists may
drive harder for a bargain
● intrusion - venture capitalists will
want to influence the company's
strategic direction
● control - venture capitalists will
interested in taking control of the
company if the management is
unable to drive the business
Debt Factoring (disadvantages)
● Reduction in profit margins on each
order or service fulfilment
● Some customers may prefer to deal
directly with the business.
● The factor deals with the customers
and not choosing a reputable can
damage business reputation.
 ● Option of fixed rate loans, where the interest rate doesn't change for the life of the loan.
2.
Bank Loan (disadvantage)

● Difficult to obtain without a substantial track record

● Possibility of seizure of personal assets in some cases
● High-interest rates, sometimes can't get enough funding to meet business needs
3.
Business Angels (advantages)

● Free to make fast investment decisions

● No need for collateral
● Access to investor's knowledge
● No repayments or interest
4.
Business Angels (disadvantages)

● Takes longer to find a suitable business angel investor

● Requires giving up a share of your business
● Less structural support than from an investing company
5.
Cash at Bank (advantages)

● highly liquid
● cash can be accessed at any time
6.
Cash at Bank (disadvantages)

● Inflation can grow at a faster rate​ ​than these low yield investments
● Business loses spending power
7.
Debentures (advantages)

● Different to shareholders are there are no voting rights

8.
Debentures (disadvantages)

● High cost of raising capital, high stamp duty.

● Must pay interest irrespective of the non-availability of profits
● Change in earnings can prove fatal for the company
9.
Debt Factoring (advantages)
 ● Debt factoring companies are usually competitive on price.
● Frees up time to manage business.
● Assists in ensuring smoother cashflow and financial planning
● Debt factoring companies will always pay you back.
10.
Debt Factoring (disadvantages)

● Reduction in profit margins on each order or service fulfilment

● Some customers may prefer to deal directly with the business.
● The factor deals with the customers and not choosing a reputable can damage business
reputation.
11.
Government Assistance (advantages)

● Can provide huge amounts of investments

● Gives an organisation exposure and credibility and public exposure.
12.
Government Assistance (disadvantages)

○ Very competitive and hard to get

○ Must be spent according to complex regulations and laws
○ Often based on a reimbursements system
13.
Hire Purchase (advantages)

● Item belongs to the business once all payments are made.

● Higher acceptance rates than other forms of unsecured borrowing.
14.
Hire Purchase (disadvantages)

● item can be repossessed if payments are missed

● usually costs more than buying the item upfront
15.
Issue Share Capital (advantages)

● helpful in raising long term capital for the company

● enable the business to expand, or invest in assets that will enable it to grow in the
future.
● The company does not need to repay this share capital, but instead agrees to distribute
future profits to stockholders in return for their investment.
16.
Issue Share Capital (disadvantage)

● Owners no longer have full control of the business

 ● Business becomes accountable to stockholders
● Stockholders can block plans if they believe they pose too great a risk to their
investment.
17.
Leasing (advantages)

● lease startup costs are lower than buying equipment/premises upfront

● you can claim lease payments as business expenses
● relocating from a leased property can be easier than depending on the sale of an owned
premise
18.
Leasing (disadvantage)

● more expensive that outright purchase over the long term

● lessee never actually own the item
● rent money does not contribute to business assets or capital growth
● you depend on the landlord for maintenance
19.
Mortgage (advantages)

● can keep ownership of business and business premises. no requirement to give up

business control or ownership.
● can make substantial capital gain
● tax deductible interest repayments
● fixed interest options
● lower interest rates than overdrafts
20.
Mortgage (disadvantage)

● need a decent sized deposit. (money which could be used for other purposes)
● harder to move business when premises are owned rather than leased
● variable rate mortgages are vulnerable to mortgage rate increases
● if the property loses value, capital will be reduced
21.
Overdraft (advantages)

● flexible - an overdraft is there when you need it, allows the business to make essential
payments whilst chasing up your own payments, helps maintain cash-flow
● quick - overdrafts are easy and quick to arrange, providing a good cash-flow backup
with minimum fuss
22.
Overdraft (disadvantage)
 ● Cost - overdrafts carry interest fees, at much higher rates than loans. - expensive for
long-term borrowing, legal charges if overdraft limit is exceeded
● Recall - the bank can recall an overdraft at any time
● Security - overdrafts may need to be secured against business assets, which puts them
at risk if repayments aren't met
23.
Retained Profits (advantages)

● self dependence - don't need to approach anyone for a loan

● saving on interest - no interest payments
● maintaining secrecy - no financial position documents have to be released to a lender
● can be used to pay dividends
● may be issue share bonuses
24.
Retained Profits (disadvantage)

● profit deprivation - depriving shareholders of money owed to them

● can be misused by company management
● can lead to over-capitalisation
● long-term retained profit is wasteful, prompt deployment of those funds could help the
business grow
25.
Sale of asset (advantages)

● quick money
● ability to reduce debt
● can have tax benefits
26.
Sale of asset (disadvantage)

● can incur taxes

● reduce's a company's capital value
27.
Trade Credit (advantages)

● reduced capital requirements

● improves cash flows
● businesses can buy now and pay later, can pay for products after they have been sold
and profit made
● business can focus on sales, marketing and research
28.
Trade Credit (disadvantage)
 ● if repayments are not made by deadlines, the business will receive a poor credit history
which will severely damage the business's ability to secure loans
● only companies with credit history will get trade credit, this is especially difficult for
new businesses
29.
Venture Capital (advantages)

● Mentoring - venture capitalists provide companies with ongoing strategic, operational

and financial advice.
● Alliances - venture capitalists can introduce the company to a network of strategic
partners
● Venture capitalists are experienced at organising IPOs
30.
Trade credit (disadvantage)

● pricing - venture capitalists may drive harder for a bargain

● intrusion - venture capitalists will want to influence the company's strategic direction
● control - venture capitalists will interested in taking control of the company if the
management is unable to drive the business
Short term​ refers to the current fiscal (tax) year. In terms of external sources of finance, this
means anything that has to be repaid to creditors within the next twelve months.

Medium term​ refers to the time period of more than twelve months but less than five years.
Medium term sources of finance include commercial loans or hire purchase agreements in excess
of a year.

Long term​ refers to any period of five years or longer. The longer the time period in question,
the harder it becomes to plan effectively. Examples of long-term sources of finance include
long-term loans such as mortgages and debentures.