Difference Between Internal Source and External Source of Finance

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.

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. 

Internal Source vs External Source

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, 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
DefinitionInternal 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 CapitalVery lowMedium to very high
CollateralNo collateral is neededCollateral is needed all the time. 
ApplicationIt is used when funding is limited. It is used when funding is needed a lot.
Amount sourcedLow to mediumMedium 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, plowing 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 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.

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 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

  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.

Conclusion

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. 

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
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