Internal Source vs External Source of Finance: Difference and Comparison

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.

Key Takeaways

1. Internal source of finance comes from within the organization, such as retained earnings. In contrast, an external source of finance comes from outside the organization, such as bank loans or issuing bonds.
2. An internal source of finance does not require repayment, while an external source of finance requires repayment with interest.
3. An internal source of finance has no direct cost, while an external source of finance has a direct cost in the form of interest or dividends.

Internal Source vs External Source

An internal source of finance is a method to raise funds within the business itself, and this causes the cost of capital to be low with no collateral needed. An external source of finance is a method of fundraising that is gotten from outside the business like a loan, and so collateral is always needed.

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.

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 and hire purchase, and the third is short-term, which includes bank overdraft, debt factoring, etc.

Comparison Table

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.

Internal sources of finance include the sale of surplus goods, ploughing back of profit items, expediting the collection of goods received, etc.

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.

The source amount is less and used in limited numbers. There is no requirement for 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.

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.

The source of external financing is large and has several uses. There is a requirement for collateral at all times to raise funds from external sources. External sources of finance are expensive by nature. 

Main Differences Between Internal Source and External Source

1. The internal source of finance is economical, while the external source of finance is expensive. 
2. 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.

References

1. https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/financing-frictions-and-the-substitution-between-internal-and-external-funds/4C26363DE11E4568E7A5C5BFE8E718F7
2. https://www.tandfonline.com/doi/pdf/10.2469/faj.v31.n6.30
3. https://meridian.allenpress.com/accounting-horizons/article-abstract/26/2/219/99200