External financing and internal financing of the enterprise: types, classification and features

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

In the process of analyzing decisions related to the capital structure, company leaders operate with such concepts as internal and external sources of financing of the enterprise.

These categories of incoming funds are relevant for almost every organization. Depending on the scope of its activities, external financing and internal financing are applied in different proportions. Sometimes it is enough to attract quite small amounts from investors and creditors, in other cases the lion's share of the company's capital is borrowed funds. This article will describe the main external and internal sources of business financing. In addition, their characteristics and examples will be given, advantages and disadvantages will be highlighted.

What is external funding and domestic funding?

Domestic financing is calledself-support of all expenses for the development of the company (when using own income). Sources of such income can be:

• Net profit received as a result of conducting financial and economic activities.
• Depreciation savings.
• Accounts payable.
• Reserve funds.
• Funds set aside for future expenses.
• Deferred income.

An example of internal financing is the investment of profits in the purchase of additional equipment, the construction of a new building, workshop or other building.

External financing involves the use of funds received from outside the company.

They can be provided by founders, citizens, the state, financial and credit organizations or non-financial companies. The key to the successful operation of an enterprise, its development and competitiveness lies in the correct and efficient combination of internal and external sources of financing. The ratio of own and borrowed funds depends on the field of activity of the company, its size and strategic plans.

Types of financing

Besides being divided into two main groups, internal and external funding sources are classified in more detail.

Domestic:

• Due to net profit.
• Depreciation charges.
• Sale of free assets.
• Income fromproperty for rent.

Outer:

• Investment funds.
• Loans (loans, leasing, promissory note).

In practice, a mixed system is most often used: both external and internal business financing.

What is domestic funding?

Today, companies themselves are engaged in the distribution of profits, the amount of which directly depends on how profitable business operations are and how effective the dividend policy is.

Based on the fact that managers are interested in the most rational use of the funds at their disposal, they make sure that the most important factors are taken into account:

• Plans for the further development of the company have been implemented.
• The interests of owners, employees, investors were observed.

With the successful distribution of finances and the expansion of the scale of the company's business activities, the need for additional financing is reduced. This shows the relationship that characterizes internal and external sources of funding.

The goal of most business owners is to reduce costs and increase profits, no matter what type of funds are used.

Positive and negative aspects of using your own financial resources

External financing and internal financing, as well as their effectiveness, are characterized by how convenient and profitable it is for managers to usethese types of cash.

The indisputable advantage of internal financing, of course, is the absence of the need to pay for the cost of raising capital from outside. Also of great importance is the ability of the owners to maintain control of the company.

Among the shortcomings inherent in domestic financing, the most significant is the impossibility of its practical application. An example is the insolvency of sinking funds. They have almost completely lost their significance due to the total reduction in depreciation rates at most domestic enterprises (in the industrial sector). Their amounts cannot be used to purchase new fixed assets. Even the introduction of accelerated depreciation does not save the situation, since it cannot be applied to the equipment that exists now.

What is hidden under the term "external sources of financing"?

With a lack of own funds, business leaders are forced to resort to borrowing or investment finance.

Along with the obvious advantages of this approach (the ability to increase business volumes or develop new market areas), there is a need to return borrowed funds and pay dividends to investors.

Searching for foreign investors often becomes a "lifeline" for many businesses. However, with an increase in the share of such investments, the possibility of control by the owners of enterprises is significantly reduced.

Credit and its specifics

Credits as an instrument of external financing become the most accessible way out for the owners of the company if the internal sources turn out to be insolvent. External financing of the firm's budget should be sufficient to increase the volume of production, as well as return the funds raised with accrued interest and dividends.

A loan is a sum of money that the lender provides to the borrower with the condition of returning the money issued and the agreed percentage for the right to use this service.

Peculiarities of using credit funds to finance a company

Benefits of loans:

• The specificity of the credit form of financing is the relative independence of the borrower regarding the application of the amounts issued to him (the absence of additional conditions).
• Often, in order to obtain a loan, the owner of a company applies to the bank that services a particular company, so the process of considering an application and issuing funds is quite fast.

Disadvantages of attracting loans:

• Quite often, a loan is issued to an enterprise for a short period (up to three years). If the firm's strategy is to generate long-term profits, the pressure on credit obligations becomes too great.
• To receive funds on credit, the company mustprovide a deposit equivalent to the desired amount.
• Sometimes a condition for a loan is the bank's requirement to open an account, which is not always beneficial for the company.

Both external and internal sources of business financing should be used as rationally and appropriately as possible, because the level of profitability of the enterprise and its attractiveness to investors depends on it.

Leasing: definition, conditions and characteristics

Leasing is a complex of various forms of entrepreneurial techniques that are beneficial for the lessor and the lessee, as they allow the first to expand the boundaries of activity, and the second to update the composition of fixed assets.

The terms of a leasing agreement are more liberal than lending, as they allow the business owner to count on deferred payments and implement a large-scale project without large financial investments.

Leasing does not affect the balance of own and borrowed funds, that is, it does not violate the ratio that characterizes the external / internal financing of the enterprise. For this reason, it does not become a hindrance to obtaining a loan.

It is interesting that when purchasing equipment under the terms of a leasing agreement, the company has the right not to put it on the balance sheet during the entire period of the document. Thus, the manager has the opportunity to save on taxes because assets do not increase.

Conclusion

External funding and domestic fundingenterprises involves using their own income or raising borrowed funds from lenders, partners and investors.

For the successful operation of the company, it is of great importance to maintain the optimal ratio of these types of financing, as well as rational and justified spending of any resources.