Internal sources of finance refer to the money generated from internal business operations. It’s considered one of the safest sources of finance in terms of cost, risk, and other financing terms. Further, this source of financing enables the business to remain debt-free and obtain maximum profitability for the owners/shareholders.
Let’s discuss some of the main ways to generate the finance internally.
1-Retained earnings
Retained earnings are the profit accumulated by the business in the past. Following are some of the features of retained earning that make it an attractive source of finance.
- The business does not have to pay the cost of interest.
- The business does not have to pay a dividend.
- It’s a quickly available reserve.
- The projects financed with the retained earnings are expected to produce higher IRR than those financed with other sources of finance. That’s because the business does not have to incur the cost of financing.
Retained earnings are so-called because they are developed with the retention of profits from the normal run of the business. Further, the use of retained earnings for investments in projects whose Internal rate of return (IRR) is higher is expected to greatly contribute towards shareholders wealth maximization positively.
Advantages of using retained earnings as a source of finance
Following are some of the benefits of using retained earnings as a source of finance,
- The business does not have to worry about paying back.
- There is no increase in the leverage risk or dilution in the controls.
- No issue cost and no payments for the interest/dividend.
- Investing retained earnings in the business projects with a greater IRR than the existing ROI of the business seems to increase the return of the shareholders.
Disadvantages of using retained earnings as a source of finance
There are no such disadvantages of using retained earnings as a source of finance. However, the business may consider paying the retained earnings as a dividend and raise some financing via debt; this can be a cheap source of finance due to a tax advantage.
2-Sale of Fixed Assets
Another important source of internal finance is the sale of business-owned assets. These assets may include fixed assets, inventory, and other assets. However, the purpose of sales should be to raise money.
The cash generated by the business via the selling of assets is considered to meet the financing needs. Further, no interest expenses are associated with this mode of financing. However, the operational efficiency of the business may be compromised if some crucial assets are sold.
Advantages of using the sale of assets as a source of finance
The business is free to sell any size of the asset depending on their need for business finance. For instance, if the business needs a small number of funds, they can sell the car/inventory, etc. On the other hand, if the business needs significant funds to finance some long-term project, it can sell land/building. Hence, this source of financing is flexible and efficient in meeting the need of the business.
Disadvantages of using the sale of assets as a source of finance
The sale of assets may lead to disturbance in the operations of the business. However, in this case, the perfect solution can be sale and leaseback that protects the asset’s operational status.
3-Debt Collection
The timely collection of debts saves a company from the risks of bad debts and assists them in using this money for investment purposes. The management of any business is responsible for making appropriate credit policies for customers. This will help in the timely collection of receivables and aid the process of financial funding of projects.
Timely debt collection will also speed up the cycle of trade debtors, which can be a helpful tool to reduce working capital.
4-Discounted Selling
This is the technique to boost up a company’s sales by offering a discount to the customers. In this method, unsold inventory/stock pile-up is sold at a discounted sale price. Generally, this technique sells out left-over stock after the end of any season/fashion, etc. This enables the business to realize the cash on the sale of slow-moving or stuck inventory.
5-Delayed payment to suppliers:
The credit time for payments of debts can be increased by making some arrangements with suppliers. This technique will be helpful for a business to grow as now they can invest such funds for business activities, and it will improve the working capital cycle as well. This technique is more useful during a crisis as the businesses get cash in hand to run their day-to-day operations.
6-Reduced Stock Level
If a company maintains excess stocks, it will increase the storage cost and impact the cash balance. So, instead of using a large portion of cash for buying stock, the company can allocate cash resources for managing other aspects of the business.
7-Reduction in the working capital cycle
The working capital cycle refers to the complete cycle the cash is tied from the purchase of inventory to the sale and receipt of the cash. For instance, one entire working capital cycle includes a period related to the following,
+Inventory days
+Receivable days
-Payable days
A lower cash operating cycle is better for the business as it takes less time to realize the cash. Sometimes, the cash operating cycle can be negative if payable days are higher than inventory and receivable days. Further, negative working capital is considered to be an excellent mode of working capital management.
8-Personal loan
Injecting personal capital in the finance structure of the business is also considered an internal source of finance. However, a significant limitation of financing through personal loans is the availability of funds.
9-Delayed supplier payments
Delaying supplier payments can be another way to increase the short-term availability of finance. However, if payments are delayed for a massive time, it may lead to impairment in the relationship with the suppliers.
So, there is a need to balance between the financing needs of the business and supplier relations.
10-Sell investments
If your business has performed well in the past and you have acquired investments, the investments can be sold to generate the money to be utilized in the business as a source of finance. However, do some math and compare the cost of obtaining finance with the gain you are earning currently, do consider penalties for revoking the investments before maturity.
So, get the insights that if there is the comparative benefit of raising finance via sell of investment. So, it can be a secure and less risky option to sell investments and satisfy your needs for financing.
Difference between intenral and external sources of finance
Following are some of the main differences between internal and external sources of finance.
| Internal source of finance | External source of finance |
|---|---|
| Internal finances are generated from the business operations. | External finances are generated from the lender or equity investor. |
| The process to obtain internal financing is relatively easier. | The process of obtaining external financing is relatively difficult. |
| The process to obtain internal financing is broadly indifferent to the business size. | External financing resources can be secured more easily for big business set-ups because of its history and recognition in the society. |
| Examples of internal finance sources include retained profits, sales of assets, and debt collection, etc. | Examples of external finance sources include loans, equity funds, share capital, and preference shares. |
Internal sources of finance example
Business projects are usually financed by a mix of internal and external sources, and the company has to shortlist the best option out of various means of financing. The money owed by debtors in the past is also a good source of internal finance, and therefore, debt collections also serve the purpose of internal financing.
Here are some other examples of internal sources of finance:
- Money obtained by the sale of fixed assets
- Use of profits arising as a result of business activities
- Funds obtained by the sale of stocks
The external source of finance example
External financing is commonly used for a business that needs an initial cash infusion for a new project or a business. Credit or a loan taken from a bank can suffice this need for finance for a business venture. Further, startups generally use external financial funding for initiating business activities. Examples of external finance include money invested by shareholders to buy a company’s shares.
Conclusion
An effective run of the business operations requires the availability of sufficient finance, and the finance can be raised internally or externally depending on the situation of the business.
Internal sources of finance include retained earnings, sale of the assets, reducing the length of the working capital days, selling products/services at discounts, collecting debts, and delaying supplier payment. These business activities lead to a comparative inflow of cash that can be utilized in business management.
The business may also opt to raise funds via external finance sources. The external source of finance includes debt financing and equity financing. Debt financing is considered a cheaper source of finance due to tax advantage. Tax advantage refers to the fact that payments on the interest can be deducted from the taxable income. Hence, it reduces overall tax liability and has a lower cost than equity where dividend payment is not tax allowable.
Further, the rise of finance through internal sources is considered comparatively cheaper and more flexible. For instance, retained earnings do not cost the business and can be used according to business needs; the sale of assets is flexible to finance short terms and long-term financing projects.
However, it should be noted that financing does have some costs, and the cost can be an opportunity or direct cost.
Key points
- Retained earnings are the most attractive source of finance due to zero cost of interest/dividend and minimum opportunity cost.
- Financing via payable is an excellent mode of financing. However, supplier relations need to be managed.
- A personal loan from the owner is also included in the internal source of finance.
- The most common external sources of finance include debt and equity.
- Debt is considered cheaper than equity because of tax advantage. However, financial leverage needs to be considered.
Also read, Objectives of financial management
