Difference Between Internal And External Financing

Internal and external sources of finance are viable options for any business looking to source extra finance for different business activities. Money makes the world go round, as they say, and it’s no different for businesses. You might need to look for financing from external sources or internal sources for a variety of reasons, including:

• business operations
• expansion attempts
• recruitment drives
• new product development
• new facilities

You can fund these activities in one of two ways – external v internal finance. Internal financing refers to retained profits, sale of assets and funding by you as the business owner. External sources of finance include bank loans, equity investment funds and crowdfunding.

Deciding which is right for you will depend entirely on your circumstances. To help you, though, Real Business has put together the following guide exploring the differences between external sources and internal sources of finance to help you decide what’s best for you.

What Is Internal Financing?

Internal financing comes from funding generated from within the business. Internal cash flows and assets make all the difference here. Retained earnings, asset sales and owner funds are the main ways that you can finance your business activities.

Most often internal sources of finance are used during the early stages of business as you’re starting out. You require less funds to operate at this time and short term internal financing offer a strong solution here before you start making more money as you grow.

External finance examples only seem to become important after a business has already proven itself. During the early stages of a business, the application process and administration involved in external financing simply isn’t worth it.

Internal financing is great when external finance sources are unavailable or risky – such as when the business doesn’t qualify for bank loans or has poor credit history. Business owners who don’t want to give up control of their assets or power to external financiers will also prefer this route.

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
• Owners funds

Retained Earnings

Retained earnings refer to the net profit available to the company that is kept in the business rather than distributed to shareholders. This pool of cash accumulates 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 operating needs. Avoiding pitching to lenders or investors is beneficial.
• No Financing Costs – Unlike debt financing, retaining earnings avoids interest payments 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 starts small for early-stage startups not yet profitable and is capped even for mature companies by annual profit levels. Large 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 could be 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 quicker than waiting on financing applications. Great for time-sensitive needs.
• Shed Excess Capacity – Opportunity to sell underutilised, outdated, or obsolete holdings 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.

This 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 business owner injects their 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 free up cash, putting up their 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 expenses etc – you can simply pay yourself back when you can.

Cons

• Personal Financial Risk – Ties the owner’s wealth and finances to the business, jeopardising their stability in cases of poor performance. Be careful if you choose to go this route.
• Limited Capital – Completely dependent on the owner’s current wealth and access to credit and if you need a large amount of capital for the business you may be unwilling to contribute such a large amount.

Self financing is great if you want to retain greater control, but just know that you will be tying your finances to the success of the business and you should be wary here.

What Is External Financing?

Naturally, external financing is when you get money from outside sources rather than using internal options. This typically involves a bank, lending institution or investor. When a company starts to grow quickly, they’ll often need an injection of cash to keep up. It can also be the only option open to business’ who are facing financial issues.

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.

The downside to external financing is that it usually comes with a cost attached – usually in the form of interest repayments. Most businesses will see this as a worthwhile move for overall business growth though.

External Financing Options Pros And Cons

• Bank Loans
• Equity Investment
• Crowdfunding

Bank Loans

Bank loans offer debt financing available from banks and other lending institutions that can be used to help with business operations, expansion goals 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 where a set amount of money is borrowed then a fixed repayment schedule is agreed upon to repay the full amount plus interest.
• Lines of credit like business overdrafts can be used with pre-approved borrowing limits. This can be used on a flexible basis and is useful for cash flow fluctuations.
• Equipment financing is often used for big purchases such as photocopiers, or speciality manufacturing equipment and allows the cost of big-ticket items to be spread over some time.
• Small business loans especially focus on business lending and will 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, meaning manageable monthly payments rather than a balloon repayment.
• Tax Deductible Interest – The interest expenses incurred on bank loans can directly reduce taxable income.

Cons

• Repayment Burden – Monthly principal and interest payments will be owed regardless of cash flow.
• Loss Of Some Control – Loan agreements contain restrictive covenants on finances, operations, and other factors that restrict certain business decisions.

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.

Common sources of equity financing include:

• Angel Investors – Wealthy individuals who invest their capital in early-stage startups.
• Venture Capital Firms – Professionally managed funds that invest in companies with high growth potential.
• Private Equity Firms – Similar to VC firms but invest in more mature, established businesses instead of startups.
• Crowdfunding Platforms – Companies sell equity stakes to many 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 along with their money.

Cons

• Loss of Control and Ownership Stakes – Issuing more company shares dilutes founders’/executives’ ownership percentages and decision power.
• 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 good 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 a great 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 to combine with large amounts of cash needed. Social media, Kickstarter and SeedInvest are examples of crowdfunding platforms.

Pros

• Tap a Wide Investor Pool – Businesses have the potential to reach millions of potential investors instead of accreditation-limited angel and VC 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 if contributing 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 ventures.

Difference Between Internal And External Financing 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 internal and external finance sources. 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.