Internal and External Sources of Finance Explained

Internal sources of finance come from within a business. External sources come from outside it. The difference is where the money comes from, not what the business plans to spend it on.

Internal sources

Retained profit is profit kept in the business rather than paid out to owners or shareholders. Selling unused assets, such as equipment the business no longer needs, can also raise cash. A business may release cash by reducing the amount tied up in working capital, for example by collecting customer payments sooner. Working capital is the money available for day-to-day operations.

Internal finance usually avoids interest payments and does not bring in new owners. However, the amount available may be limited. Selling an asset could also reduce the business’s ability to operate if it still needs that asset.

External sources

Bank loans provide a sum that is repaid over time, usually with interest. An overdraft allows a business to borrow through its bank account, often to cover short-term cash shortages. Share capital raises money by selling shares, though this may reduce existing owners’ control. Trade credit lets a business buy from suppliers and pay later. These are external sources because the finance is provided by lenders, investors or suppliers outside the business.

For example, if a business needs £20,000\pounds 20{,}000£20,000 for new equipment, it could use £8,000\pounds 8{,}000£8,000 of retained profit and take out a £12,000\pounds 12{,}000£12,000 bank loan. The first amount is internal finance; the loan is external finance.

Common exam mistake: Do not call a bank loan internal finance just because the money is spent inside the business. Classify it by its source, then consider whether its cost, repayment terms and effect on control suit the business.