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Imagine you own a business that urgently needs money. You do not have much time and there is nobody else to help you - you and the business are totally self-sufficient. What do you do? You probably think about the money available to you. Perhaps you have savings or you earn well. Or, you think about using money earned by the business. Alternatively, you may think about selling things your business does not need anymore. All of these options represent internal sources of finance.
Internal sources of finance include all the money coming from inside the business. It can come from the business itself, but it can also come from its owners. It may be money that the business has earned, which can be reinvested to cover expenses.
The term Internal sources of finance refers to money that comes from inside the business.
There are two categories of sources of finance, internal and external. Which one do you think comes from inside the business? If you said internal, you're right. Outside? External is correct.
The term external sources of finance refers to money that comes from outside the business. This may include bank loans or mortgages, overdrafts, new share issues, hire purchases, government grants, loans from friends and family, or trade credit.
Whereas internal sources of finance include money raised internally, i.e. by the business or its owners, they do not include funds that are raised externally, i.e. by external parties such as banks, new shareholders, suppliers, government, friends, family, etc.
There are several types of internal sources of finance a business can raise. They can be raised by the business itself or by its owners. There are three common types of internal sources of finance (see figure 1).
Figure 1. Types of internal sources of finance, StudySmarter
Owners can use their own money to cover business expenses and invest in the business. Owners’ funds are monies that entrepreneurs bring into the business. These funds typically originate from their personal savings, but they can also be earned by the owners, who are sometimes employed elsewhere.
Owners’ funds are a cheap, quick, and easy source of finance. As there is no interest, this source of finance is the least expensive. It is also easy to raise, as it can be arranged immediately. However, using owners’ funds as a source of finance is not always possible, as entrepreneurs might not have enough money to bring into the business.
This source of finance is very often used by new businesses. The reason for this is that when planning to set up a business, entrepreneurs typically save money to invest in it.
Alice is planning on opening an ice cream shop. Several months before setting up the business, she started to put away 30% of her monthly salary to save money to buy a venue and equipment for the ice cream shop. Alice's savings are an example of an internal source of finance.
Businesses can also use the money they generate. When a business makes a profit from its sales, it can reinvest it into the business.
Retained profits are a relatively cheap, quick, and easy source of finance because there are no interest charges and they can be arranged immediately. Nevertheless, retained profits can be used by profitable businesses only.
A florist in London runs a very profitable business. The profit the firm generates is more than enough to pay all the business expenses and pay salaries to its employees and owners. Therefore the florist has decided to expand and open up another shop using the money from its sales. The florist's retained profits are also an example of an internal source of finance.
To raise money internally, businesses can also sell some of their assets to make money from items they no longer needs for its daily operations. These may include additional vehicles, equipment, and machinery.
As there are no interest rates, this is a relatively cheap method to raise finance. However, it is only possible for businesses that have suitable assets.
A fast-food restaurant used to employ its own drivers, who would deliver food to customers. However, it abandoned the idea and switched to an external delivery provider instead. As the business used to provide its drivers with cars and bikes, it is now in possession of several vehicles it does not need anymore. Therefore, it decided to sell them to generate cash, another example of an internal source of finance.
Using internal sources of finance has both benefits and limitations. Let's take a closer look.
Low cost. As you might have noticed, none of the internal sources of finance involves costs such as interest rates or other fees. This is because by taking money from itself, a business will not have to pay additional fees.
Retention of control and ownership. Sourcing finance from itself, a business does not allow external parties to control it and take over the ownership. In doing so, it retains both control and ownership.
No approvals needed. When a business sources finance from itself, it does not need to ask anyone to approve it. It can raise funds whenever needed without asking for permission.
No legal obligations. By raising money internally, the business is not legally obligated to pay anyone back. In fact, it does not have to pay back any money at all. This is because there are no contracts or third parties involved in the financing.
Limited amount of finance. When a business sources finance from itself, it can only take the amount of money it possesses. It cannot raise any more because it simply does not have it.
Lack of possibility. To use the internal sources of finance, a business has to either be profitable, possess unwanted assets, or its owners have to have money. If none of these options are present, it is impossible to raise finance.
As you can see, businesses can raise money without involving any other parties. They do it by using owners’ funds, retained profits, or selling unwanted assets. All of these methods have advantages and disadvantages that have to be considered carefully in order to raise a sufficient amount of money on time.
The internal sources of finance refer to money that comes from inside the business. It can come from the business itself but it can also come from its owners.
The internal sources of finance can be: owners’ funds, retained profits and selling unwanted assets.
The difference between internal and external sources of finance is that internal sources of finance come from inside the business and external sources of finance some from outside of the business.
The advantages of internal sources of finance include low costs, the retention of control and ownership, no approvals needed and no legal obligations.
The disadvantages of internal sources of finance are the limited amount of finance and constricted number of options.
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