Internal Finance Sources
Internal sourses of finance
Retained profit • Personal savings • Sale of unwanted assets
• Sale and leaseback
Internal sources of finance refer to the funds generated within the organization or by the
business owner, without the need to rely on external lenders or investors. Here’s a brief
explanation of each internal source you mentioned:
1. Retained Profit:
Profits that a business has kept from previous years instead of distributing them as
dividends to shareholders. These funds can be reinvested into the business for growth
or operational needs.
Advantages: No interest costs, readily available.
Disadvantages: Limited by the business’s profitability.
2. Personal Savings:
Money invested by the business owner from their personal funds. This is common in
startups or small businesses.
Advantages: No repayment obligations or interest.
Disadvantages: Risk of losing personal wealth.
3. Sale of Unwanted Assets:
Selling off business assets that are no longer in use or essential to operations, such as
old machinery or unused buildings.
Advantages: Frees up cash from non-productive assets.
Disadvantages: May lead to loss of resources needed in the future.
4. Sale and Leaseback:
Selling an asset, such as property or equipment, to a leasing company and then leasing
it back for continued use.
Advantages: Generates immediate cash while retaining use of the asset.
Disadvantages: Increases long-term costs due to leasing payments.
These internal sources are ideal for businesses looking to avoid debt or external dependency
but are often limited in scale.
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External Sources of Finance
• Finance provided by people or institutions outside the
business, creates a debt that will require payment
• Examples • Loans • Overdraft • Shares • Debentures
External sources of finance refer to funds obtained from individuals, institutions, or investors
outside the business. These sources often create a financial obligation that requires
repayment, often with interest, or sharing of ownership. Here’s a breakdown of each
example:
1. Loans
Borrowed money from banks, financial institutions, or individuals, typically repaid with
interest over a fixed period.
Advantages: Large amounts can be raised; repayment is spread over time.
Disadvantages: Interest costs; assets may need to be used as collateral.
2. Overdraft
A short-term borrowing facility where a business can withdraw more money than it has in its
bank account, up to an agreed limit.
Advantages: Flexible and quick access to funds; useful for covering cash flow shortages.
Disadvantages: High interest rates; usually for short-term needs only.
3. Shares
Selling ownership (equity) in the business to investors or the public in exchange for capital.
Advantages: No repayment obligation; large sums can be raised.
Disadvantages: Dilution of ownership and control; shareholders expect dividends and
growth.
4. Debentures
Long-term loans issued by a company to investors, with a promise to pay fixed interest and
repay the principal at a specified time.
Advantages: Fixed interest costs; retains ownership as no shares are issued.
Disadvantages: Interest must be paid regardless of profit; adds to long-term liabilities.
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Key Features of External Finance:
Often larger sums than internal sources.
Comes with conditions like interest, repayment schedules, or loss of control (in the case
of shares).
Suitable for significant investments or when internal sources are insufficient.
Short Term Financing Options
1. Spontaneous Financing A. Trade Credit B. Advance from
Customer C. Accrued Expenses
2. Money Market Credit A. Commercial Paper B. Banker’s
acceptance
3. Unsecured Bank Loan A. Transaction Loan B. Line of
Credit C. Revolving Credit
4. Secured Bank Loan A. Account Receivables B. Inventory
of Goods
Short-term financing options are used to meet immediate financial needs, generally for a
period of less than one year. Here’s a detailed explanation of the options you mentioned:
1. Spontaneous Financing
Funds that arise naturally from the day-to-day operations of a business without formal
agreements.
A. Trade Credit:
Credit extended by suppliers allowing businesses to purchase goods and pay later.
Advantages: Easy to obtain, no interest if paid on time.
Disadvantages: Late payments may incur penalties or harm relationships.
B. Advance from Customer:
Payments received from customers before the delivery of goods or services.
Advantages: Immediate cash inflow, reduces working capital requirements.
Disadvantages: Obligates the business to deliver as promised.
C. Accrued Expenses:
Expenses incurred but not yet paid, like salaries or utility bills.
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Advantages: No explicit cost of financing.
Disadvantages: Limited to the nature of ongoing expenses.
2. Money Market Credit
Short-term financing obtained through the money market.
A. Commercial Paper:
Unsecured, short-term promissory notes issued by large, creditworthy companies.
Advantages: Lower interest rates than bank loans.
Disadvantages: Limited to companies with high credit ratings.
B. Banker’s Acceptance:
A short-term debt instrument guaranteed by a bank, often used in international trade.
Advantages: Bank guarantee increases reliability.
Disadvantages: Costs associated with banking fees.
3. Unsecured Bank Loan
Short-term loans without collateral, based on the creditworthiness of the borrower.
A. Transaction Loan:
A one-time loan for specific business needs, like purchasing inventory.
Advantages: Flexible usage.
Disadvantages: Higher interest rates due to no collateral.
B. Line of Credit:
An agreed credit limit with a bank, where businesses can draw funds as needed.
Advantages: Pay interest only on the amount used.
Disadvantages: May involve fees for unused credit.
C. Revolving Credit:
Similar to a line of credit but with more flexibility to borrow, repay, and reborrow within a
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limit.
Advantages: Continuous access to funds.
Disadvantages: Higher fees and interest rates.
4. Secured Bank Loan
Short-term loans secured by collateral, reducing risk for lenders.
A. Accounts Receivable Financing:
Borrowing against outstanding invoices.
Advantages: Converts receivables into cash quickly.
Disadvantages: Dependent on customer payments.
B. Inventory Financing:
Loans secured by a business’s inventory.
Advantages: Allows inventory purchase or optimization.
Disadvantages: Inventory valuation challenges may limit loan amount.
These short-term financing options provide businesses with flexibility to manage working
capital and handle temporary cash flow challenges efficiently.
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