Investment is an important factor when it comes to keeping a business running, so it’s important to know where your money is coming from. There are many ways in which you can grow your business and raise money for investment. Mainly these can be divided into two categories: internal sources of finance and external sources of finance.
Internal Source vs External Source
The main difference between internal source and external source of finance is that internal source of finance is a type of fundraising system which exists in the business itself whereas the external source of finance comes from the outside of the business. One is self-sufficient funding while the other one involves outside investors.
Fundraising refers to internal sources of finance that exist within the business itself. It involves using methods to increase our daily profits, such as selling stocks or services. This can also include business assets, which emerge as an important option when you are looking for the right options to convert and reduce your business. It can also be a very useful way to make the most of assets that are no longer as popular.
An external source of finance As the name suggests, this external source comes from the organization. It has various categories, the first of which is of long duration, they include shares, debentures, grants, bank loans, etc.; The second is short term, which includes leasing, hire purchase; And third is short term, which includes bank overdraft, debt factoring, etc.
Comparison Table Between Internal Source and External Source
| Parameters of comparison | Internal Source | External Source |
| Definition | Internal source of finance is a type of fundraising system which exists in the business itself | The external source of finance comes from the outside of the business. |
| Cost of Capital | Very low | Medium to very high |
| Collateral | No collateral is needed | Collateral is needed all the time. |
| Application | It is used when funding is limited. | It is used when funding is needed a lot. |
| Amount sourced | Low to medium | Medium to high |
What is Internal Source?
In business, internal sources of finance mainly refer to our total assets and the amount that we collect daily. Its objective is to increase the money received from business activities. Budgeting and cost appraisal and control are considered to be the main and essential for this main purpose. The credit terms of the customers are verified so that the amount received is well maintained regularly.
Internal sources of finance include the sale of surplus goods, plowing back of profit items, expediting the collection of goods received, etc. Fundraising refers to internal sources of finance that exist within the business itself.
It involves using methods to increase our daily profits, such as selling stocks or services. This can also include business assets, which emerge as an important option when you are looking for the right options to convert and reduce your business. It can also be a very useful way to make the most of assets that are no longer as popular.
The source amount is less and used in limited numbers. There is no requirement of collateral in internal sources of finance for raising funds. The internal source of finance is economic. It is not that expensive.
What is External Source?
External sources of finance are funds derived from cash collected from outside the organization, wherever it may be from. In external funding, money is raised from outside sources to grow the business. An external source of finance As the name suggests, this external source comes from the organization. These are mainly of two types, in which there are long term sources and short term sources. They involve outside investors.
They are divided into two parts based on nature and that is equity financing and debt financing.
Debt Financing: This is all about the fixed payment that is made to lenders. This is called debt financing. This type of financing includes bank loaning, corporate bonds, leasing, commercial paper, trade credits, debentures, etc.
Equity Financing: It is all about the shares which indicate the ownership stake of the firm by the companies and the interest of the shareholders. Companies sell their shares to investors and recover that amount from there. This type of financing includes ordinary shares and preference shares.
The source amount in external financing is large and has several uses. There is a requirement of collateral for all time to raise funds from external sources. External sources of finance are expensive by nature.
Main Differences Between Internal Source and External Source
- Internal sources of finance include Debt collection, sales of assets, etc. whereas External Source of finance includes issuing existing or new shares, financial institutions, loans from banks.
- Internal sources could be in limited amounts and can not be fully utilized On the other hand the External financing is large and has several uses.
- Internal sources don’t need any collateral for fundraising whereas External sources of finance require collateral for all time to raise funds.
- The internal source of finance is economical while the external source of finance is expensive.
- Internal Source of finance doesn’t provide any tax benefits whereas External Source of finance may involve paying interest which helps in tax deduction on profits.
Conclusion
So here we conclude that both the sources are important at their respective place. One source is economical by nature while the other one is expensive. One is self-sufficient funding while the other one involves outside investors. One requires limited funding while the other one requires a lot of funding. Many factors change the decision taken by the owner, and they also determine the source of funds chosen. The most important of these factors is considered to be the period for which money is required. So this is how they are different from each other.
References
- https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/financing-frictions-and-the-substitution-between-internal-and-external-funds/4C26363DE11E4568E7A5C5BFE8E718F7
- https://www.tandfonline.com/doi/pdf/10.2469/faj.v31.n6.30
- https://meridian.allenpress.com/accounting-horizons/article-abstract/26/2/219/99200