To provide internal and external finance means to engage in business activities using either money from within a company or funds from outside. This is the key and most important difference between these two funding options. When a company uses internal finance, it takes advantage of existing supplies of capital from profits and other sources. External finance involves the use of money new to the company, from outside sources, to fund planned activities.
There are advantages and disadvantages to both approaches. Companies considering internal and external finance typically start by exploring internal options. They calculate the planned cost of a project to determine if enough money will be available, and think about what kind of position the company may be in during development. One problem with the use of internal funds can be a lack of flexibility and decreased capital, which means a company could be vulnerable if it suddenly needs cash and has none available.
External finance requires either going into debt or giving up control. Companies can borrow money in a variety of ways, take shares public, or solicit venture capitalists to invest directly. All of these can compromise a company and highlight the difference between internal and external finance. For one, the company has limited flexibility and high control, and with the other, companies have flexibility, but must give up control in order to access it. Companies with publicly traded shares, for instance, are vulnerable to takeover.
Differences between internal and external finance can determine how a company proceeds with business decisions. Sources of external funding can be limited if a company does not seem like a good investment prospect or appears to be a poor credit risk. This can limit opportunities for external finance, as a company might not be willing to pay high interest or take other tradeoffs to access capital. Internal finance is limited to what a company can raise on its own, and how much liquidity it is willing to sacrifice to bring a given project to completion. Liquidity can be a substantial issue if projects cost more than companies expect, as they may end up dedicating additional internal funds that they won’t be able to access rapidly.
Consultants can provide advice on both internal and external finance for companies that are not sure about which would be most appropriate or effective for a given application. The consultant can review financial documentation and the planned activity to offer balanced advice. For some firms, it may make more sense to keep funding internal, while others may benefit from external sources of capital, and would not be at risk from the increased debt or loss of control.