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Business finance guide
Internal and external sources of finance for a business: advantages and disadvantages
Internal and external sources of finance for UK businesses: retained profit, owner capital, loans, overdrafts, asset and invoice finance, with pros and cons.
In this guide
Every business is funded from two places: money it already has or generates, and money it raises from others. Knowing the advantages and disadvantages of each source helps you choose the cheapest one that fits the need, and explain your plan to a lender. This guide covers both. We are a broker: we arrange external finance by searching the market, and we will tell you when an internal source makes more sense.
Internal sources of finance
| Source | Advantages | Disadvantages |
|---|---|---|
| Retained profit | No interest, no repayments, no loss of control | Takes time to build; cash spent is not available for emergencies |
| Owner's capital or director loans | Quick; shows lenders commitment | Puts personal money at risk; limited by personal wealth |
| Selling surplus assets | Releases cash tied up in unused equipment or property | One-off; the asset is gone; may sell below value if rushed |
| Better working capital management | Chasing debtors, cutting stock and agreeing supplier terms frees cash at no cost | Gains are limited and can strain customer and supplier relationships |
Our guide to calculating working capital shows how much cash is tied up in day-to-day trading.
External sources of finance
| Source | Advantages | Disadvantages |
|---|---|---|
| Business loans | Fixed sum and term; you keep ownership; interest is a business cost | Interest and fees; repayments due whatever happens; often a personal guarantee |
| Overdraft | Flexible; interest only on what you use | Repayable on demand; usually small limits |
| Asset finance | The asset secures it; spreads the cost over the asset's life | Only for assets lenders will finance; you may not own it until the end |
| Invoice finance | Grows with sales; turns invoices into cash in days | Fees on turnover; only for business-to-business sales |
| Trade credit | Free if paid on time; no application | Short terms; late payment damages supplier relationships |
| Equity investment | No repayments; investors may bring expertise | You give up a share of the business and of future profits |
| Crowdfunding | Raises money and customers at once | Public, time-consuming, and not guaranteed to reach its target |
| Grants | Not repaid | Competitive, slow, tied to specific purposes; often need match funding |
We arrange debt finance such as loans, asset finance and invoice finance; we do not arrange equity or grants. Our guides to debt vs equity funding and business grants vs business loans cover those.
Which source suits which need
| Need | Usually best funded by |
|---|---|
| Short cash flow gap | Working capital management, overdraft, revolving credit or invoice finance |
| Vehicles and equipment | Asset finance, or retained profit if cash is plentiful |
| Premises | Commercial mortgage plus a deposit from retained profit |
| Buying a business | Acquisition finance, owner's capital and vendor finance |
| High-risk growth with no profit yet | Equity, grants or start-up loans |
A cost example
A business needs £40,000 for new equipment. Paying from retained profit costs no interest but leaves £40,000 less cash in the bank. Financing it over four years at an illustrative 9% a year (inside the range asset lenders on our panel publish; see the rate index) costs about £995 a month and £7,775 of interest in total, while keeping the cash available. Whether the interest is worth paying depends on how much buffer the business needs and what else the cash could earn.
Advantages and disadvantages of borrowing compared with internal funds
- Borrowing keeps cash in the business for emergencies and opportunities, and the interest is a business cost.
- Internal funds cost nothing and add no risk, but once spent they are gone.
- Borrowing commits future cash flow and usually needs a guarantee or security.
- Mixing both is common: lenders like to see the owners' own money in a deal.
Our guide to the pros and cons of business loans goes into borrowing in more depth.
How we can help
This guide is general information, not financial advice. Lenders set their own criteria, rates and terms, and all finance is subject to status.
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FAQs
Common questions
What are internal sources of finance?
Money from inside the business: retained profit, owners' capital or director loans, selling surplus assets and freeing cash from working capital. They cost no interest but are limited by what the business and its owners have.
What are external sources of finance?
Money from outside the business: bank and specialist loans, overdrafts, asset finance, invoice finance, trade credit, equity investors, crowdfunding and grants.
What are the disadvantages of external sources of finance?
Debt costs interest and fees, must be repaid whatever happens, and often needs a personal guarantee or security. Equity means giving up part of the business. Grants are slow and competitive. The right choice depends on the need and the business's position.
Is a director's loan an internal or external source of finance?
Usually treated as internal, because it comes from the owners rather than an outside lender. Our guide to the directors' loan account explains how it works.
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