There are two general sources of finance that are available to a business today. Short-term finance sources must be paid back within 12 months. Long-term finance sources are allowed to be paid back over many years instead.
Within these sources, you can have either internal or external sources of finance as well. When dealing with internal sources of finance only, you are talking about funds which are found within the business itself. One example of an internal source of funds would be profits that are held back to fund an expansion of company resources.
That is compared to an external resource, which would come from a lender or creditor.
There are several advantages and disadvantages to consider when exploring internal sources of finance to meet short-term or long-term needs. Here are the key points to look at.
List of the Advantages of Internal Sources of Finance
1. It allows an organization to maintain full control.
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.
2. It improves the planning process.
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.
3. It reduces the overall cost of most projects.
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 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.
List of the Disadvantages of Internal Sources of Finance
1. It may have a negative impact on your operating budget.
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 requires accurate estimates to be 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 may have fewer tax benefits for the organization.
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 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.
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.
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.