Internal and External Sources of Finance

All businesses need money. Where the money comes from is known as ‘sources of finance’. Now there are two different types of sources of finance: internal (finance from inside the business) and external (finance from outside the business). New businesses starting up need money to invest in long-term assets such as buildings and equipment. They also need cash to purchase materials, pay wages, and to pay the day-today- bills such as water and electricity. In-experienced entrepreneurs (or social entrepreneurs) often underestimate the capital needed for the everyday running of the business. Generally, for every £1000 required to establish the business, another £1000 is needed for day-to-day needs. This is why sources of finance is crucial for any business.

Internal Sources of Finance

  • Existing capital can be made to stretch further. The business may be able to negotiate to pay its bills later or work at getting cash in earlier from customers; the average small firm waits 75 days to be paid (i.e. two and a half months); if that period of time could be halved; it would provide a huge boost to cash flow.
  • Profit! Over 60% of business investments comes from reinvested profit.

External Sources of Finance 

If a business needs to generate more finance and can’t internally, they may seek for external sources of finance. There are two types: loan capital and share capital. Please also see ‘Factors that Affect the Choice of Finance‘.

Loan Capital

The most common way is through borrowing from a bank. This can be in a form of an overdraft or loan. and is usually set over a period of time. It could be short (2-3 years), medium (3-5 years) or long term (5+ years). There will be an interest rate on the loan, either fixed or variable. The bank will demand a collateral to provide security in case the loan cannot be repaid.

An overdraft is basically a very short-term loan. This lets the business be ‘overdrawn’ or ‘fall into the red’ in which to what extent is negotiated. Overdrafts have a much higher rate of interest than loans.

Share Capital

On the other hand, if the business is a limited company, it may look for additional share capital. This could come from private investors or venture capital funds. Venture capital providers are interested in investing in businesses with dynamic growth prospects. They are willing to take a risk if a business fails, or does well. The way it works is that a venture capitalist invests in ten businesses, five could flop, four do okay and one does amazingly well. Peter Theil, the original investor in Facebook, probably turned his $0.5 million investment into $200 million: a nice profit of 400%.

Once the business has become a public limited company, it can float onto the stock exchange where it can sell shares to the public.

The Advantages and Disadvantages of Sources of Finance

Internal Sources

Reinvested Profit

+ Profit can provide a return for investors in which investors plough back into business to help it grow.
+ Does not have associated costs.
+ Does not have to be repaid unlike loans.
+ No interest charges.
May be limited which will constrain rate at which business expands.

Cash Squeezed Out by Day-to-Day Finance

+ Reduces amount needed to be borrowed (cutting stocks, chasing up customers or delaying payments to suppliers).
Very short term solution.

Sale of Assets

+ Sold to raise cash.
+ Makes sense to dispose of underused assets.
+ Finance development without extra borrowing.
+ They can sale and lease it back.
Loses assets but has the use of the cash.

External Sources

Bank Overdrafts

+ The firm only needs to borrow only when and as much as it needs.
Very expensive and bank can insist being repaid within 24 hours.

Trade Credit

+ Good way of boosting day-to-day finance.
Other businesses may be reluctant to trade with the business if they do not get paid in good time.

Venture Capital

+ Usually want to contribute to the running of the business – bring in new experience and knowledge.
Requires a substantial part of the ownership of the company.

Finding finance may involve balancing conflicting interests. Internal sources of finance may be too limited to provide opportunities for business development. Obtaining external finance increases the money available, but has its downsides. Borrowing too much can be risky. Raising extra share capital dilutes the control held by existing shareholders.

Having adequate and appropriate finance at each stage in the firm’s development will ensure it stays healthy. Decisions about where to obtain the finance will be a matter of considering the business objectives, the stage of development of the the business and the reasons for the funding requirement. A well-run business plans ahead for its financing needs. To run out of cash (as with Northern Rock did) suggests management incompetence.

Key Terms

Collateralan asset used as security for a loan. It can be sold by a lender if the borrower fails to pay back a loan.
Over-tradingwhen a firm expands without adequate and appropriate funding.
Public limited company (plc) – a company with limited liability, and shares that are available to the public. It’s shares can be quoted on the stock market.
Share capitalbusiness finance that has no guarantee of repayment or of annual income, but gains a share of the control of the business and its potential profits.
Stock marketa market for buying and selling company shares. It supervises the issuing of shares by companies. It is also a second-hand market for stocks and shares.
Venture capitalhigh-risk capital invested in a combination of loans and shares, usually in a small, dynamic business.

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