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
- 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.
- An internal source of finance does not require repayment, while an external source of finance requires repayment with interest.
- 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
- 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.
- 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
Last Updated : 26 August, 2023
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
Am I the only one who feels like this post is just being overly didactic in an attempt to sound intelligent?
I actually didn’t find the post to be overly pedantic.
I see what you mean, but the post is beneficial nevertheless.
The author provides a comprehensive comparison between internal and external sources of finance.
I absolutely agree, the understanding gained from reading the post is invaluable.
This is a good article, a very informative description of internal and external sources of finance.
I agree, it’s an excellent guide for businesses in managing their finances.
I never knew that. Thank you for the enlightenment. I will now be able to better manage my finances.
Indeed, invest your money wisely. It is the key to financial freedom.
I concur, very informative. Thanks.
This post is laden with errors as to the nature of internal and external sources of finance.
I appreciate the post for the valuable information it provides.
I respectfully disagree. I think the post offers a clear and concise distinction between the two.
This article deftly compares the various components of internal and external financing.
Reading this article was an intellectual treat. Such stimulating content.
Reading between the lines, I think the post is a bit biased towards internal financing and lacks a balanced comparison with external financing.
I see your point, perhaps a more comparative approach would provide a clearer portrait of both internal and external financing.
I think this post is wrong. This is not what internal and external sources of finance mean,
Could you please explain why?
It would be great to provide some evidence to support your point.