Internal and external sources of finance for a business: advantages and disadvantages

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.

01Internal sources of finance

Our guide to calculating working capital shows how much cash is tied up in day-to-day trading.

02External sources of finance

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.

03Is it internal or external? A quick check

The test is simple. If the money comes from the business itself or from what it already owns, it is internal. If it comes from someone outside the business, such as a bank, a supplier, an investor or the government, it is external. These are the sources people most often ask about.

04Which source suits which need

05A 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.

06Advantages 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.

07Short-term, medium-term and long-term sources of finance

Sources are also grouped by how long the money is needed for. Business studies courses commonly use under a year for short term, one to five years for medium term and over five years for long term. The rule of thumb is to match the finance to the life of what it pays for, so a three-year van is not funded with an overdraft that can be withdrawn at any time.

Our guide to a revolving credit facility vs a term loan explains when flexible borrowing suits better than a fixed loan.

08Sources of finance for a small business or start-up

The sources open to a business depend on its age and size. A new business has no retained profit and no trading record, so its choices are narrower.

• Start-ups usually rely on the owner's savings, money from family and friends, asset finance for equipment and government-backed Start Up Loans, which are personal loans for people starting or growing a business.
• Sole traders and partnerships can borrow, but the owners are personally responsible for the debt, so lenders look closely at personal credit.
• Established limited companies can use retained profit and the full range of external finance, from term loans and invoice finance to revolving credit and selling shares.

The government's finance and support finder lists public schemes and grants, and the British Business Bank publishes impartial guides to each type of finance.

09How to choose between internal and external finance

Five questions settle most decisions.

1. How much, and how soon? Internal funds are quick but limited. External finance can be larger but takes time to arrange.
2. How long is it needed for? Match the term to the life of the asset or the length of the gap.
3. What does it cost in total? Compare the interest and fees on borrowing with what the cash would otherwise earn or protect. Our business loan calculator shows repayments and total interest, and the rate index shows the ranges lenders publish.
4. Who keeps control? Debt is repaid and ends. Equity means sharing ownership and future profits.
5. What happens if things go wrong? Borrowing must be repaid whatever happens and often needs a personal guarantee, while spending all your cash reserves leaves no buffer.

Many businesses use both, for example a deposit from retained profit with asset finance for the rest. Lenders like to see the owners putting in some of their own money.

10How we can help

Many businesses use both, for example a deposit from retained profit with asset finance for the rest.