Difference Between Internal Source and External Source of Finance

Edited by Diffzy | Updated on: November 01, 2022

       

Difference Between Internal Source and External Source of Finance Difference Between Internal Source and External Source of Finance

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Introduction

The term “business” refers to the commercial activity of producing and distributing goods and services to end-users for profit. An entity requires money to engage in various business activities, and thus finance is referred to as the “spine” of business, which keeps it running. The capital brought into the business by the proprietor is insufficient to meet the financial needs, so he or she seeks new ways to meet fixed capital and working capital requirements. It is classified into internal and external sources based on the source of generation, with the former covering those means generated within the business.

The latter, on the other hand, refers to funds generated by sources other than the business, such as investors, lending institutions, and so on.

A company can raise funds from several different sources, each with its own set of characteristics. To find the best available source of finance to meet our needs, we must first understand the fundamental aspects of the various sources of finance. In this article, we’ll look at the distinctions between internal and external sources of funding.

Internal vs External Sources of Finance

The difference between internal sources of finance and external sources of finance is Internal sources of finance are types of fundraising systems that exist within the business itself, whereas external sources of finance come from outside the business. The first is self-sufficiency funding, while the second entails the involvement of outside investors.

Internal sources of finance, known as fundraising, exist within the business. It entails using methods such as the sale of stocks or services to increase our daily profits. This can also include business assets, which are an important consideration when determining the best ways to convert and reduce your business. It can also be a very effective way of maximizing the value of assets that are no longer in high demand.

A funding source from outside the organization As the name implies, this external source is from the organization. It is divided into three categories: long-term (shares, debentures, grants, bank loans, and so on), short-term (leasing and hire purchase), and short-term (bank overdraft, debt factoring, and so on).

Difference between External Sources of finance and Internal sources of finance in tabular form

Table: Internal vs External Sources of Finance
Parameters of Comparison
Internal sources
External sources
Definition
It is present in the business itself
Comes from 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 are Internal Sources of Finance?

Internal sources of finance in the business refer to funds raised from existing assets and the company’s day-to-day operations. Its goal is to boost the cash flow generated by normal business operations. Cost evaluation and control, as well as budget review, are used to accomplish this. To effectively manage receivables collection, credit terms with customers are also verified.

Internal sources of finance include the sale of excess inventory, profit reinvestment, and the acceleration of receivables collection, among other things.

It entails using methods such as the sale of stocks or services to increase our daily profits. This can also include business assets, which are an important consideration when determining the best ways to convert and reduce your business. It can also be a very effective way of maximizing the value of assets that are no longer in high demand.

The source amount is smaller, and it is used in smaller amounts. Internal sources of finance do not necessitate the use of collateral to raise funds. Economic finance is a type of internal financing. It is not prohibitively costly.

What are External Sources of Finance?

External sources of finance are cash flows generated by an organization from sources other than its own, whether private or financial Obtaining funds from sources other than the business is referred to as external financing. External sources of finance are divided into two types: long-term and short-term sources of finance. They are further classified according to their nature as follows:

Debt financing is a type of financing in which the borrower must make a fixed payment to the lender. It contains the following items:

  1. Bank advances
  2. Corporation-issued bonds
  3. Trade Credit Leasing for Commercial Paper Debentures

Financing through equity: For the vast majority of businesses, equity is the primary source of funding, indicating the firm’s ownership stake and the shareholders’ interest. Companies raise capital by selling shares to investors. It contains the following items:

  1. Ordinary capital shares
  2. Preference Shares

External financing has a significant source amount that can be used for a variety of purposes. Collateral is always required when raising funds from outside sources. External sources of funding are, by definition, costly.

Main Difference Between Internal and External Sources of Finance in Points

  1. Internal sources of finance are cash flows generated within a company. External sources of finance, on the other hand, are funds raised from sources other than the organization, such as the private sector or the financial market.
  2. Internal sources of finance do not require collateral for fundraising, whereas external sources of finance do require collateral at all times.
  3. The amount raised from internal sources is less, and it can only be used for a few purposes. Large sums of money, on the other hand, can be raised from outside sources for a variety of purposes.
  4. Internal financing sources include stock sales, fixed asset sales, retained earnings, and debt collection. Financial Institutions, Bank Loans, Preference Shares, debentures, Public Deposits, Lease Financing, Commercial Paper, Trade Credit, Factoring, and so on are examples of external sources of finance.
  5. Internal sources of finance are less expensive than external sources of finance.

Conclusion

As a result, we can conclude that both sources are significant in and of themselves. One source is naturally cheap, whereas the other is expensive. The first is self-sufficiency funding, while the second entails the involvement of outside investors.

One requires a small sum of money, while the other requires a large sum of money. Many factors influence the decision of the owner, as well as the source of funds chosen. The most important of these factors is the time frame for which money is required. This is how they are distinguished from one another.

A variety of factors influence the owner’s decision regarding the source of funds to be used. These factors include the time frame for which funds are required, the reason for raising funds, and the total amount of funds required by the firm.


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"Difference Between Internal Source and External Source of Finance." Diffzy.com, 2022. Sun. 27 Nov. 2022. <https://www.diffzy.com/article/difference-between-internal-source-and-external-source-1079>.



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