Internal and External Sources of Funds, Essay Example

The difference between internal and external sources of funds is that internal sources of funds are generated by the firm itself through its operating activities or capital provided by the founders while external sources of funds are stakeholders outside the organization that provide temporary funds to the organization. The examples of internal sources of funds include retained earnings, owner capital, and sale of assets while external sources of funds include bank loans, debt/equity issue, accounts payable, and leasing (Vause). Both internal and external sources of funds have certain advantages and shortcomings.

As far as retained earnings are concerned, the companies normally have two options when it comes to their net income. They can either distribute them to the owners/shareholders in the form of dividends or retain them to fund future growth. When investment opportunities are abundant, the shareholders may benefit more by earning dividends and investing the income somewhere else with higher income potential. Otherwise it may be better for the company to retain earnings if it believes it can invest them more profitably than the shareholders. Retained earnings also allow companies to avoid interest payments should they access bank loans and improve operating liquidity. In addition, companies don’t have to worry about repaying any loan. Owner capital is another internal source of funds but owners’ are usually limited in the amount of resources they can provide. Most owner capital is usually provided when companies are founded but such sources are expensive since owners earn a significant ownership stake.

The companies can also sell assets to generate funds. Unprofitable assets do not only provide much-needed funds and they may even improve operating efficiency by reducing the asset base. But the company may not always have sufficient assets that could be sold or be sold at reasonable prices and this is also not a feasible option when the companies are looking to add additional assets to expand production capacity instead of reducing the asset base.

One of the commonly-utilized external sources of funds is bank loans. The amount of loan as well as the interest rate depends upon the company’s credit history. In addition, the bank may impose certain covenants to reduce its risk and protect itself against potential default of principle and interest payments by the company. The benefit of bank loans is that If the company has a good credit history, it can obtain quite generous terms from the bank and bank loans can be secured quite quickly. The shortcoming of this option is that interest payments negatively affect the company’s short-term liquidity and in addition, the interest and principal payment have to be made irrespective of the company’s financial performance and economic conditions. Similarly, the company can issue debt or equity to the general public. The debt issue has quite similar advantages and disadvantages to bank loans but funds obtained from equity issue do not have to be repaid. At the same time there are no interest obligations but equity issue does dilute the ownership of existing shareholders and may even reduce their dividend income (Johnston).

Accounts payable allow companies to obtain material from suppliers in advance while delaying payments to some future date. Accounts payable help companies improve operating liquidity but too much delay and a history of missed payments may deteriorate its relationship with suppliers. Leasing is another option. One of the benefits of leasing is that it helps companies expand without incurring huge capital investments. Leasing is also beneficial because operating leases help companies improve balance sheet and moreover, leasing is better when companies often need to replace assets (Food and Agriculture Organization of the United Nations).

Internal sources of funds are used by companies that have superior financial position and generate enough profits to finance their growth plans and acquisition goals. Examples include Apple and Google that are sitting on billions of dollars in retaining profits. But most companies do not earn sufficient funds to fully fund asset replacement and growth plans, thus, external sources of funds such as bank loans, credit lines, and accounts payable are employed by a significant proportion of companies. Most companies use a mixture of internal and external sources of funds but the financing needs of most companies exceed the amount that could be generated internally.

References

Food and Agriculture Organization of the United Nations. (n.d.). Sources of finance. Retrieved July 15, 2012, from http://www.fao.org/docrep/W4343E/w4343e08.htm

Johnston, K. (n.d.). The Advantages of Internal Funding. Retrieved July 15, 2012, from http://smallbusiness.chron.com/advantages-internal-funding-24209.html

Vause, B. (n.d.). Guide to Analysing Companies. September 9, 2009: Bloomberg Press.