Internal finance uses existing capital from profits and other sources, while external finance involves using new money from external sources. Both have advantages and disadvantages, and companies may need to seek advice to determine which option is best for them. External financing can involve borrowing or giving up control, while internal financing can limit flexibility and liquidity.
Providing internal and external finance means engaging in business using internal money or external funds. This is the key and most important difference between these two financing options. When a company uses internal finance, it leverages existing supplies of capital from profits and other sources. External financing involves using money new to the business, from external sources, to finance planned activities.
There are advantages and disadvantages to both approaches. Companies considering internal and external finance typically start by exploring internal options. They calculate the planned cost of a project to determine if sufficient funds will be available, and think about the type of position the company can take during development. A problem with using internal funds can be a lack of flexibility and shrinkage of capital, meaning a company could be vulnerable if it suddenly needs cash and has none on hand.
External finance requires borrowing or giving up control. Companies can borrow money in a variety of ways, take public shares or solicit venture capitalists to invest directly. All of this can undermine a company and highlight the difference between internal and external finance. On the one hand, society has limited flexibility and control, and on the other hand, businesses have flexibility, but they have to access it to access it. Companies with publicly traded shares, for example, are vulnerable to takeover.
The differences between internal and external finance can determine how a company makes business decisions. Sources of external financing may be limited if a company does not appear to have good investment prospects or appears to have poor credit risk. This can limit external financing opportunities, as a company may not be willing to pay high interest or make other trade-offs to access capital. Internal finance is limited to what a company can raise on its own and how much cash it is willing to sacrifice to complete a given project. Liquidity can be a substantial issue if projects cost more than companies expect, as they may end up dedicating additional internal funds that they won’t be able to access quickly.
Consultants can advise on both internal and external financing for companies who are unsure which would be more appropriate or effective for a given application. The consultant can review financial documentation and planned activity to offer balanced advice. For some companies, it may make more sense to maintain internal financing, while others may benefit from external sources of capital and would not be at risk from rising debt or loss of control.
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