In the process of analyzing decisions related to the capital structure, company executives use concepts such as internal and external sources of enterprise financing.
These categories of incoming funds are relevant for almost every organization. Depending on the scope of its activities, external financing and internal financing are used in various proportions. Sometimes it’s enough to attract quite small amounts from investors and creditors, in other cases the lion's share of the company's capital is borrowed funds. This article will describe the main external and internal sources of financing a business. In addition, their characteristics and examples will be given, the advantages and disadvantages are highlighted.
What are external financing and internal financing?
Internal financing is the independent provision of all expenses for the development of the company (using its own income). Sources of such revenues can be:
- Net profit resulting from financial and economic activities.
- Depreciation accumulation.
- Accounts payable.
- Reserve funds.
- Deferred funds for future expenses.
- Income received against a future period.
An example of internal financing is investing the profits in the purchase of additional equipment, the construction of a new building, workshop or other building.
External financing involves the use of funds received from outside the company.
They can be provided by founders, citizens, the state, financial and credit organizations or non-financial companies. The key to the success of the enterprise, its development and competitiveness is to correctly and efficiently combine internal and external sources of financing. The ratio of own and borrowed funds depends on the scope of the company, its size and strategic plans.
Types of financing
In addition to the division into two main groups, internal and external sources of financing are classified in more detail.
Internal:
- Due to net profit.
- Depreciation deductions.
- Sale of free assets.
- Income from the rental of property.
External:
- Investment funds.
- Loans (loans, leasing, promissory notes).
In practice, the most commonly used mixed system: both external and internal business financing.
What is domestic financing?
Today, companies themselves are engaged in the distribution of profit, the value of which directly depends on how profitable business operations and effective dividend policy.
Based on the fact that managers are interested in the most rational use of the means at their disposal, they make sure that the most important factors are taken into account:
- Implemented plans for the further development of the company.
- The interests of owners, employees, and investors were respected.
With the successful distribution of finances and the expansion of the scope of the company's business, the need for additional financing is reduced. This shows the relationship characterizing internal and external sources of financing.
The goal of most business owners can be called the desire to reduce costs and increase profits, regardless of what type of funds will be used.
The positive and negative aspects of the use of own cash resources
External financing and internal financing, as well as their effectiveness, are characterized by how convenient and profitable it is for managers to use these types of funds.
The indisputable advantages of domestic financing, of course, is the lack of the need to pay the cost of raising capital from outside. Also of great importance is the ability of owners to maintain control of the company.
Among the shortcomings inherent in domestic financing, the most significant is the impossibility of its practical application. An example is the failure of depreciation funds. They almost completely lost their value due to a total decrease in depreciation rates at most domestic enterprises (in the industrial sector). Their amounts cannot be used to purchase new fixed assets. The situation does not save even the introduction of an accelerated depreciation order, since it cannot be applied to the equipment that exists now.
What is hidden under the term “external sources of financing”?
With a lack of own funds, enterprise managers are forced to resort to borrowing or investment finance.
Along with the obvious advantages of this approach (the ability to increase business volumes or to develop new areas of the market), there is a need to return borrowed funds and pay dividends to investors.
The search for foreign investors often becomes a lifeline for many enterprises. However, with an increase in the share of such investments, the ability of owners of enterprises to control is significantly reduced.
Credit and its specifics
Loans as an external financing tool become the most affordable way out for company owners if internal sources turn out to be insolvent. External financing of the budget of the company should be enough to increase production, as well as return the borrowed funds with accrued interest and dividends.
Credit is the amount of money that the lender provides to the borrower subject to the return of the issued money and the agreed percentage for the right to use this service.
Features of using credit funds to finance a company
Advantages of loans:
- The specificity of the credit form of financing becomes the relative independence of the borrower regarding the application of the amounts issued to him (lack of additional conditions).
- Often, to obtain a loan, the owner of the company turns to the bank that provides services to a particular company, so the process of considering an application and issuing financial resources is quite quick.
Disadvantages of attracting loans:
- Often a loan is granted to an enterprise for a short period (up to three years). If the firm’s strategy is to make long-term profits, the pressure on credit obligations becomes too great.
- To receive funds on credit, the company is obliged to provide a security equivalent to the desired amount.
- Sometimes the condition for lending becomes the requirement of the bank to open an account, which is not always beneficial for the company.
Both external and internal sources of financing a business should be used as rationally and appropriately as the level of profitability of an enterprise and its attractiveness to investors depend on it.
Leasing: definition, conditions and characteristics
Leasing is a complex of various forms of entrepreneurial practices that are beneficial for the lessor and lessee, as they allow the former to expand the boundaries of its activities, and the latter to update the composition of fixed assets.
The terms of the leasing agreement are more liberal in comparison with lending, as they allow the business owner to count on deferred payments and implement a large-scale project without major financial investments.
Leasing does not affect the balance of own and borrowed funds, that is, it does not violate the ratio characterizing the external / internal financing of the enterprise. For this reason, he does not become an obstacle to obtaining a loan.
It is interesting that when buying equipment under the terms of a leasing agreement, the company has the right not to put it on balance for the entire period of the document. Thus, the manager has the opportunity to save on taxes because assets are not increasing.
Conclusion
External financing and internal financing of enterprises involves the use of own revenues or borrowing from lenders, partners and investors.
For the successful operation of the company, it is of great importance to observe the optimal balance of these types of financing, as well as the rational and justified expenditure of any resources.