Most of the time, these sources of finance are external and may come with some conditions. However, sometimes finance can also be generated from within the business. This is known as internal financing.
A business can generate internal financing in many ways. It is mainly done through the revenue earned from sale of stock or services.
When these revenues are earned, they are kept for use within the business and not distributed to the owners, known as retained earnings.
Internal financing can also be generated through the sale of fixed assets that a business does not need anymore. Businesses that allow credit transactions can also generate finance by collecting their debts.
Internal sources of finance can have many advantages for a business but they come with some disadvantages as well.
The advantages of internal source of financing are as follows:
1) No Dilution of Ownership and Control
The biggest advantage of internal sources of finance is that it avoids the dilution of ownership and control. A business, by using an internal source of financing, retains its ownership.
For example, if a business funds its finance through equity finance, the new equity holders will have to be given some form of control over the decisions of the business for the capital they have invested in the business.
Generally, equity instruments also come with voting rights for companies. This means that new investors coming into the company will also get to make and contribute to the decision-making process of a business.
This may prove bad for a business as it may cause conflicts between existing owners and new owners. New owners of the business may not share the same ideas and vision for the business as the old owners.
On the other hand, debt finance may require a business to offer an asset as security in exchange for the finance provided.
This finance may come with some sort of restrictions on the use of the asset. This means the asset will no longer be in the full control of the business.
2) No Legal Obligations
Internal source of finance comes with no legal obligations to pay anyone. This is different from other sources of finance such as debt finance where the business is legally obliged to pay the debt providers.
In case these obligations are not paid on time, the business may also have to face legal actions. Businesses also have to pay interest to the debt providers for the finance they have provided to the company. The same does not apply to internal financing.
3) Lower Cost
The cost of capital of internal financing is also lower as compared to other sources of finance.
For example, if a company wants to obtain equity finance, it will have to comply with stock market regulations and also pay fees involved with issuing shares, etc.
Similarly, the company has to pay interest fees and offer assets as security to obtain debt finance. Both of these costs are avoided when internal financing is used.
4) No Approvals Needed
When funds are generated internally, the business does not need permission of equity or debt holders to use these funds.
A business that uses equity or debt finance generated externally instead of internally generated finance is forced to wait for approval of the equity or debt providers for decision.
This can also make the decision-making process of a business slower and vital opportunities might be missed waiting for approval.
5) Improves the Value of the Business
Internally generated funds also help improve the value of the business. These funds retained in the business help increase the value of the equity instruments of the business.
Furthermore, internally generated finance, unlike debt finance, improve the gearing ratio of a business which makes investment in the business attractive for potential investors.
6) Helps Improve Business Credit Rating
When a business generates internal funds and uses those funds in daily operations, it helps establish the business’ credit ratings.
Financial institutions are more likely to give loans to a business that can show the potential to generate finance to repay the loan. Moreover, unlike debt finance, it does not adversely affect the credit rating of a business.
Internal financing can also have some disadvantages, as below:
1) Not Ideal for Long-term Projects
When internal finance is used to fund the activities of the business, the growth is limited by the rate at which the business can generate internal finance.
A business is highly unlikely to generate enough internal finance to fund long-term projects at a constant rate. Therefore, external finance is always needed and preferred when investing in long-term projects.
In addition, using internally generated funds to finance long-term projects needs proper planning and forecasting. This requires accurate forecasting to predict the exact returns and time of those returns for it to be effective.
Once internal financing is used for a long-term project, the business also needs to keep tight control over the project to ensure the funds are recovered. If the spending is not closely controlled, the business might have to face bankruptcy threats.
2) Effects of Other Business Operations
If an internal source of finance is used to fund a long-term project, this may adversely affect the daily operations of the business. Using internal finance to fund a long-term project means the internal finance has to be generated from somewhere.
This finance may then be generated by cutting the budgets of other departments of the business. This can further affect the ability of the business to generate more funds to finance the project.
3) Loss of Tax Benefits
Debt financing comes with the benefit of tax deductions for the interest payments made by a business.
When internal finance is used, this tax benefit is lost. For businesses that pay a high tax percentage based on their income, an internal source of finance may not be beneficial.
4) No External Expertise or Networks
External sources of finance may also bring expertise or networking opportunities to businesses.
For example, when venture capitalists invest in a business, they bring expertise and networking to businesses, which is invaluable in itself for startups. When the internal source of finance is used, this advantage is lost.
Businesses can choose between using internal or external sources of finance for their activities or upcoming projects. Using an internal source of finance can give the business many advantages such as avoiding dilution of ownership and control, lower costs, and improving the business value.
However, it may come with some disadvantages such as not being ideal for long-term projects, loss of tax advantages, and loss of expertise and networking.