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Internal Sources of Finance

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Business Studies

Imagine you own a business that urgently needs money. You do not have much time and there is nobody else to help you - you and the business are totally self-sufficient. What do you do? You probably think about the money available to you. Perhaps you have savings or you earn well. Or, you think about using money earned by the business. Alternatively, you may think about selling things your business does not need anymore. All of these options represent internal sources of finance.

What are internal sources of finance?

Internal sources of finance include all the money coming from inside the business. It can come from the business itself, but it can also come from its owners. It may be money that the business has earned, which can be reinvested to cover expenses.

The term Internal sources of finance refers to money that comes from inside the business.

Difference between internal and external sources of finance

There are two categories of sources of finance, internal and external. Which one do you think comes from inside the business? If you said internal, you're right. Outside? External is correct.

The term external sources of finance refers to money that comes from outside the business. This may include bank loans or mortgages, overdrafts, new share issues, hire purchases, government grants, loans from friends and family, or trade credit.

Whereas internal sources of finance include money raised internally, i.e. by the business or its owners, they do not include funds that are raised externally, i.e. by external parties such as banks, new shareholders, suppliers, government, friends, family, etc.

Types of internal sources of finance

There are several types of internal sources of finance a business can raise. They can be raised by the business itself or by its owners. There are three common types of internal sources of finance (see figure 1).

Internal Sources of Finance, Types of internal sources of finance, StudySmarterFigure 1. Types of internal sources of finance, StudySmarter

Internal Sources of Finance: Owners’ funds

Owners can use their own money to cover business expenses and invest in the business. Owners’ funds are monies that entrepreneurs bring into the business. These funds typically originate from their personal savings, but they can also be earned by the owners, who are sometimes employed elsewhere.

Owners’ funds are a cheap, quick, and easy source of finance. As there is no interest, this source of finance is the least expensive. It is also easy to raise, as it can be arranged immediately. However, using owners’ funds as a source of finance is not always possible, as entrepreneurs might not have enough money to bring into the business.

This source of finance is very often used by new businesses. The reason for this is that when planning to set up a business, entrepreneurs typically save money to invest in it.

Alice is planning on opening an ice cream shop. Several months before setting up the business, she started to put away 30% of her monthly salary to save money to buy a venue and equipment for the ice cream shop. Alice's savings are an example of an internal source of finance.

Internal Sources of Finance: Retained profits

Businesses can also use the money they generate. When a business makes a profit from its sales, it can reinvest it into the business.

Retained profits are a relatively cheap, quick, and easy source of finance because there are no interest charges and they can be arranged immediately. Nevertheless, retained profits can be used by profitable businesses only.

A florist in London runs a very profitable business. The profit the firm generates is more than enough to pay all the business expenses and pay salaries to its employees and owners. Therefore the florist has decided to expand and open up another shop using the money from its sales. The florist's retained profits are also an example of an internal source of finance.

Internal Sources of Finance: Selling unwanted assets

To raise money internally, businesses can also sell some of their assets to make money from items they no longer needs for its daily operations. These may include additional vehicles, equipment, and machinery.

As there are no interest rates, this is a relatively cheap method to raise finance. However, it is only possible for businesses that have suitable assets.

A fast-food restaurant used to employ its own drivers, who would deliver food to customers. However, it abandoned the idea and switched to an external delivery provider instead. As the business used to provide its drivers with cars and bikes, it is now in possession of several vehicles it does not need anymore. Therefore, it decided to sell them to generate cash, another example of an internal source of finance.

Advantages and disadvantages of internal sources of finance

Using internal sources of finance has both benefits and limitations. Let's take a closer look.

Internal Sources of Finance: Advantages

  • Low cost. As you might have noticed, none of the internal sources of finance involves costs such as interest rates or other fees. This is because by taking money from itself, a business will not have to pay additional fees.

  • Retention of control and ownership. Sourcing finance from itself, a business does not allow external parties to control it and take over the ownership. In doing so, it retains both control and ownership.

  • No approvals needed. When a business sources finance from itself, it does not need to ask anyone to approve it. It can raise funds whenever needed without asking for permission.

  • No legal obligations. By raising money internally, the business is not legally obligated to pay anyone back. In fact, it does not have to pay back any money at all. This is because there are no contracts or third parties involved in the financing.

Internal Sources of Finance: Disadvantages

  • Limited amount of finance. When a business sources finance from itself, it can only take the amount of money it possesses. It cannot raise any more because it simply does not have it.

  • Lack of possibility. To use the internal sources of finance, a business has to either be profitable, possess unwanted assets, or its owners have to have money. If none of these options are present, it is impossible to raise finance.

As you can see, businesses can raise money without involving any other parties. They do it by using owners’ funds, retained profits, or selling unwanted assets. All of these methods have advantages and disadvantages that have to be considered carefully in order to raise a sufficient amount of money on time.

Internal sources of finance - Key takeaways

  • The term internal sources of finance refers to money that comes from inside the business.
  • There are two types of sources of finance: internal (from inside the business) and external (from outside the business).
  • Examples of internal sources of finance: owners’ funds, retained profits, or selling unwanted assets.
  • The advantages of internal sources of finance are low costs, retention of control and ownership, no approvals needed, and no legal obligations.
  • The disadvantages of internal sources of finance are the limited amount of finance and constricted number of options.

Internal Sources of Finance

The internal sources of finance refer to money that comes from inside the business. It can come from the business itself but it can also come from its owners. 


The internal sources of finance can be: owners’ funds, retained profits and selling unwanted assets.


The difference between internal and external sources of finance is that internal sources of finance come from inside the business and external sources of finance some from outside of the business. 

The advantages of internal sources of finance include low costs, the retention of control and ownership, no approvals needed and no legal obligations.

The disadvantages of internal sources of finance are the limited amount of finance and constricted number of options.

Final Internal Sources of Finance Quiz

Question

Define internal sources of finance.


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Answer

Internal sources of finance refers to money that comes from inside the business.


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Question

What are the two types of sources of finance?


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Answer

Internal and external


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What is the difference between internal and external sources of finance?


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Answer

The internal sources of finance come from inside the business and external sources of finance some from outside the business. 


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Question

Give an example of an external source of finance.


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Answer

Any of these: 

  • bank loans or mortgages
  • overdrafts
  • new share issues
  • hire purchases
  • government grants
  • loans from friends and family
  • trade credit


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Question

What are the three most common types of internal sources of finance?


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Answer

  • owners’ funds
  • retained profits
  • selling unwanted assets


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If owners of a business do not have any savings and/or earnings, which type of internal sources of finance are they unable to use?


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Answer

Owners’ funds

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Which type of internal sources of finance can be used by a new business?


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Answer

Owners' funds

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If a business does not earn enough money to cover its expenses, which type of internal sources of finance is it unable to use?


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Answer

Retained profits

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Can a new business use retained profits to raise funds?


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Answer

No

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Can a new business sell unwanted assets to raise funds?

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Answer

No

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To sell unwanted assets, a business has to…


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Answer

have suitable assets.


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Retained profits can be used by ___ businesses only.


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Answer

profitable


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Question

Give an example of an advantage of internal sources of finance.


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Answer

Any of: 

  • low cost
  • control and ownership 
  • no approvals needed
  • no legal obligations


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Question

What are the disadvantages of internal sources of finance?


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Answer

  • limited amount of finance
  • lack of possibility


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Question

Why would a business be unable to raise internal sources of finance?


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Answer

To use the internal sources of finance, a business has to either be profitable, possess unwanted assets or its owners have to have money.


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Question

The term ___ refers to money that comes from outside the business. 

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Answer

external sources of finance 

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Question

Which of these are internal sources of finance?

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Answer

Owners' funds

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Which of these are internal sources of finance?

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Answer

All the answers are correct.

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Which of these are NOT internal sources of finance?

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Answer

Hire purchases

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Sourcing finance from itself, a business does not allow external parties to ___ it and take over the ___.

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Answer

control ... ownership 

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Question

Internal sources of finance involve costs such as interest rates or other fees. 


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Answer

False

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Raising finance internally, there are no legal obligations.

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Answer

True

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Internal sources of finance are limited.

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Answer

True

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It is always possible for a business to raise finance internally. 

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Answer

False

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By raising money internally, the business does not have to pay back any money at all.


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Answer

True

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Question

Give an example of assets a business can sell to raise the internal sources of finance.

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Answer

For example:

- vehicles, 

- equipment, 

- machinery.

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Question

Which sources of finance come from inside the business?

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Answer

Internal

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Which sources of finance come from outside the business?

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Answer

External

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Question

Businesses can raise money without involving any other parties. 

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Answer

True

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