Internal and external sources of finance are viable options for any business looking to source additional money for different activities. Money makes the world go round, and it’s no different in the world of business. Businesses need to look for financing from external sources or internal sources for a variety of reasons, including:
- Operational needs
- To accelerate growth and expansion
- Recruitment initiatives
- New product development
- New/larger facilities or premises
You can fund these activities in one of two ways – external vs. internal finance. Internal financing refers to retained profits, selling assets, and funding by you as the business owner. External funding includes bank loans, equity investment funds, and even crowdfunding campaigns.
Deciding which business finance is right for your needs will depend entirely on your circumstances. To help you, Real Business has put together the following guide exploring the differences between internal and external sources of finance to help you decide what’s best for your company.
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What Is Internal Financing?
Internal financing comes from funding generated from resources within the business. Retained earnings, selling assets, and owner funds are the main ways that you can finance your business activities.
Internal sources of finance are typically used during the early stages of business when you’re starting out. You’ll require less funds to operate now and short-term internal financing offers a practical and accessible solution before your business grows.
External finance seems to become more important (and available) after a business has already proven itself. During the early stages of a business, it’s harder to secure external sources of finance, and often, the application process and administration alone simply isn’t worth it.
Internal financing is the right funding when external finance sources are unavailable or risky – such as when the business doesn’t qualify for bank loans or has a poor credit history. Business owners who don’t want to give up control of their assets will prefer this route. It avoids relying on external financiers who often provide credit with multiple strings attached.
Internal financing really only faces one limit: how much spare cash is lying around from profits, assets, or your personal wealth as a business owner.
Internal Financing Options: Pros And Cons
- Retained earnings
- Sale of Assets
- Owner’s funds
Retained Earnings
Retained earnings refer to the net profit available to the company, money that is kept in the business rather than distributed to shareholders. This pool of cash accumulates and is ready to be used for future capital investments and business expansions without the need to bring in external finance.
Pros
- Easily Accessible Capital – The funds are already sitting on the balance sheet ready for deployment into growth initiatives or operational needs. It avoids pitching to lenders or investors, too.
- No Financing Costs – Unlike debt financing, retaining earnings avoids interest payments and any hidden costs for borrowing flowing out of the organisation to lenders or bondholders.
- Preserves Control – Relying on internal equity financing rather than external equity issuances prevents ownership stake dilution and loss of decision-making autonomy.
Cons
- Limited Availability – The pool is inevitably small for early-stage startups which are not yet profitable and is capped even for mature companies by annual profit levels. Significant financial needs may exceed retained earnings.
- Foregoes Other Uses – Retained capital cannot also be deployed in alternative ways like paying dividends, paying down debt early, or repurchasing company shares.
Retained earnings is the optimal form of financing for businesses but it can take time to get to this stage and is fully dependent on business success.
Sale Of Assets
Businesses have plenty of assets that can be sold to raise cash; this is also called asset monetisation. This can include property, equipment, inventory, or anything else owned by the company that could attract a monetary value through sale. The money raised can then be reinvested into the business where it’s needed.
Common categories of business assets that can be sold include:
- Property – Land, buildings, facilities, real estate
- Equipment – Machinery, tools, servers, hardware assets
- Excess Inventory – Raw materials, finished goods, components
- Intellectual Property – Patents, trademarks, licences
- Business Units – Selling divisions, product lines, brands
Pros
- Rapid Cash Influx – Asset sales can monetise tangible assets quickly rather than waiting on decisions on applications to financial institutions. It’s great for time-sensitive needs.
- Shed Excess Capacity – Opportunity to sell underutilised, outdated, or obsolete holdings which potentially are dragging down operations.
Cons
- Lost Income Potential – Selling cash-generating units risks losing their future revenue, cash flows, and lifespan value.
- Impact On Operations – Even non-revenue assets like equipment often support business workflows so their sale causes disruption.
Asset monetisation provides easy access to large sums of money, but selling fundamental assets can be incredibly difficult and costly to business operations. Make sure you shed non-essential assets first and be wise about what you sell.
Owner’s Funds
When a company uses owner’s capital to inject cash into the business, this is considered internal funding. This personal funding may come from shareholders, business owners, partners, or other principal leadership members.
Examples of owners’ funding include bootstrapping from personal savings, taking on second mortgages to create cash, putting up personal assets as collateral, borrowing from friends and family, and cashing in retirement savings.
Pros
- Full Control Retention – Avoiding external capital prevents diluting decision-making.
- No Repayment Obligations – Owner funds act as permanent capital without required interest or expenses etc – you can simply pay yourself back when you can.
Cons
- Personal Financial Risk – It ties the owner’s wealth and finances to the business, jeopardising their personal financial status if the business performs poorly. Taking this route requires caution.
- Limited Capital – Completely dependent on the owner’s current wealth and access to credit. They may be unwilling to contribute a large amount of personal capital.
Self-financing is great if you want to retain control of your business, but the stark reality is that you will be tying your own resources to the success of the business and so this decision needs to be carefully considered.
What Is External Financing?
Often external sources of finance are required when larger amounts of cash are necessary for the business – usually more than is available internally. If used in conjunction with wise business decision-making, external financing can be a great option.
External financing typically involves a bank, lending institution or investor. When a company starts to grow quickly, they’ll often require more money to support the business. A flexible external source may also be the only option open to businesses who are facing financial issues.
The downside to external financing is that it comes with a cost attached – usually in the form of interest repayments. However, most businesses will see this as a worthwhile way to raise capital because of the growth opportunities it delivers.
External Financing Options: Pros And Cons
- Bank Loans
- Equity Investment
- Crowdfunding
Bank Loans
Bank loans offer debt financing that can be used to help with business operations, expansion into new markets, and other capital needs. Money can be borrowed from these sources and repaid over a set period with interest.
Common types of bank finance include:
- Term loans which is a loan for a set amount of money with a fixed payment schedule to repay the full amount plus interest.
- Lines of credit like business overdrafts which can be used with pre-approved borrowing limits. These can be used on a flexible basis and are useful for cash flow fluctuations.
- Equipment financing is often used for big purchases such as photocopiers, or speciality manufacturing equipment or machinery, and allows the cost of big-ticket items to be spread over a specified period of time.
- Small business loans especially focus on business lending and usually have preferential/competitive interest rates.
Pros
- Access Significant Capital – Banks have more lending capacity than individual investors, with small business loans ranging from £50,000 up to £5 million+.
- Flexible Repayment Timeline – Term loans allow 2-7-year repayment schedules which can make all the difference, creating manageable monthly payments rather than a balloon repayment.
- Tax Deductible Interest – The interest expenses incurred on bank loans can directly reduce taxable income and tax liabilities.
Cons
- Repayment Burden – Monthly principal and interest payments are fixed regardless of cash flow.
- Loss Of Some Control – Loan agreements can contain restrictive covenants on finances, operations, and other factors that restrict certain business decisions. A business with a poor credit rating may find higher interest rates imposed to reflect risk.
Equity Investment
Equity finance refers to capital that is raised by selling part of the ownership stake in a business to external investors. There is no requirement to repay the funds and the external investor benefits by sharing the future business profits and company value based on their share of business equity.
Common sources of equity financing include:
- Angel Investors – Wealthy individuals who invest their capital in early-stage startups.
- Venture Capitalists – Professionally managed funds that invest in companies with high growth potential often at the early stage where other sources of finance are hard to find.
- Private Equity Firms – Similar to VC firms but invest in more mature, established businesses instead of startups.
- Crowdfunding Platforms – Companies sell equity stakes to numerous small investors through internet platforms.
Pros
- No Repayment Requirements – Equity is permanent capital as long as investors retain shares, freeing cash flow.
- Rapid Access to Capital – Can secure large investments from external sources faster than saving profits.
- Investor Experience and Networks – Many investors also provide advice, mentorship, and industry connections alongside their money.
Cons
- Loss of Control and Ownership Shares – Issuing more company shares dilutes founders’/executives’ ownership percentages and decision-making power, potentially losing control over their own business.
- Investors Claim Future Profits – By owning equity, external owners profit from future financial success.
- Ongoing Reporting Requirements – Investors typically gain information rights to receive financial statements, budgets, forecasts, and other updates that you’ll need to provide regularly.
This external financing source allows businesses to raise healthy amounts of cash based on the business’ future potential rather than its current profitability or assets.
Crowdfunding
Crowdfunding is gaining popularity all the time as an innovative way to raise money from a large pool of people. These tend to be regular members of the public rather than professional investors looking to make big profits. The idea is that many people offer small sums of money which combine to provide the large amounts of cash needed. Social media, Kickstarter, and SeedInvest are examples of crowdfunding platforms.
Pros
- Tap a Wide Investor Pool – Businesses have the opportunity to reach millions of potential investors instead of accreditation-limited angel and venture capital networks.
- Marketing Exposure – High visibility campaigns build brand awareness and customer enthusiasm even if fundraising minimums are not met.
Cons
- Complex Regulations – Equity offerings must follow rules about maximum raises, investor eligibility, disclosures and more under Regulation Crowdfunding.
- Relinquish Ownership – Equity crowdfunding does sell stakes in your company even though these are smaller individual investments.
- Numerous Stakeholders – Managing thousands of shareholders during major business decisions can be incredibly difficult.
If your business can navigate the compliance requirements, crowdfunding opens access to capital from non-traditional sources based on social momentum for high-potential and/or high-profile ventures.
Difference Between Internal And External Financing: A Summary
There are various external and internal finance sources available for businesses. The best type of funding for a business will usually be a mix of both. The key is to understand the pros and cons of each before making any major financial decisions that can impact business growth positively and negatively.
As a business owner, you’ll need to make your mind up about which option is best for you: external vs internal finance. Internal sources are great if you have the money lying around, but external sources are usually necessary where more funds are required.
Whatever the case, our guide today should serve as a helpful starting point when deciding which is right for you and your business.
