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Are internal sources of finance viable for SMEs?

Find out what it means to source business finance internally, and discover the different methods you could look to utilise in your own business.
Are internal sources of finance viable for SMEs?

Updated on 18/09/2020

Healthy finances could be one of the biggest indicators of success in businesses of all shapes and sizes. When finances are strong, businesses can be bold and creative; seeking new growth opportunities and ventures. When they’re weak, however, businesses may feel the pinch and therefore need to focus on becoming as efficient as possible instead.

Getting access to finance could help with both of these scenarios; enabling companies to capitalise upon emerging opportunities when times are good, and boosting their cash flow to help get them through the tougher times. There are plenty of sources of business finance, but in this article we’re going to explore what internal finance is, and how it could help SMEs cope with both the scenarios mentioned above.

What are internal sources of finance?

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As opposed to external sources of finance, whereby a business acquires money from a lender such as bank or online lender, internal sources of finance are raised from within a business itself.

In most cases of internal finance, the profits generated by a business become the main fuel for the fires of investment and expansion. This is obviously a great scenario for businesses to be in; if you’re financing your future off the back of your current successes, then you could potentially reduce the amount of risk involved with undertaking a new project- presuming your profits remain stable.

Alternatively, finance can be sourced internally through the sale of assets. Why would a business sell its assets, you may ask? Well, the kind of assets that a business may look to sell could include:

  • Unused assets that are taking up space without generating any significant revenue for the business or contributing to its operations.
  • Unnecessary assets, for example if a new, cheaper and more efficient technology becomes available within a market, a business may look to sell its outdated assets to fund the purchase of a new asset if they feel it could improve the health of the business.

So, how do the pros and cons of this method of financing stack up against those associated with externally sourced finance?

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

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In a literal sense, the definition of internal finance is funds raised from within your business, as opposed to from outside of it.

In a practical sense, however, there are a lot of different factors to consider when trying to gain an understanding of which finance method is the most effective:

What risks are involved with internal and external sources of finance?

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In an external finance agreement, you’re going to have to repay any money you’ve borrowed from a lender. If you’ve signed a business loan agreement, for example, then the likelihood is that you’ll have set repayment dates outlined - which you’re obliged to meet as part of the contract.

Conversely, in an internal finance agreement, the risk doesn’t lie with external parties as you’re using your own profits to fund your investments, eliminating that factor of external risk. But, by doing so, you’re also becoming more dependent on the stability of your revenues. If your revenues dip and your profits subsequently take a hit, then you may find that you’re suddenly incapable of funding your investment. This could become a problem if the project you’re funding is time-sensitive.

There’s an element of risk associated with both internal and external financing, and it’s up to you as a business owner to weigh up all the factors we discuss today as well as doing your own research to make an informed decision on which financing method would best fit your needs.

For some businesses, using internal finance means that they’re eliminating the risk of missing late repayment fees which reduces the overall risk they’re accounting for in their business plan. For others, the overall risk to their business may be reduced by having the flexibility provided by borrowing money from an accredited lender as it reduces their dependency on month-to-month cash flow.

Ultimately, aiming to reduce risk is a healthy way of managing finances for a business, and these types of financial decisions depend on a number of circumstances that are individual to you and your business’ needs. Doing your own research, seeking financial advice and weighing up your own situation could mean you secure the right finance method for your business.

Internal finance may be more limited than external finance in terms of capital sums

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Most reputable lenders will have access to vast pools of money and be lending to hundreds or thousands of businesses at any one time. What this means is that the £20,000 you’ve raised through your business’ profits has a much higher impact on your business’ continuity than the risk taken by a lender loaning you the same amount of money out of their accounts.

So, if a new project you’re undertaking becomes more costly than you had forecasted, internal financing could be unreliable. For example, if you’re expanding your premises and unexpectedly find out from a contractor that the foundations of your new building need to be re-laid, then there’s a better chance that an external lender may be able to loan you the extra funds needed to make that happen than you being able to quickly source additional funds from your profits.

Speaking of which…

Internal finance can be a slow burner

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Unless your business is experiencing a period of extensive growth, it may be difficult to raise the kind of funds needed to make substantial changes to your business, so you may need to incrementally put chunks of your profits into one pot which you can use for investment in the future.

What this requires is some advanced planning, and deliberate cash flow forecasting. By setting realistic goals and building up your investment pot over time, you can enjoy all of the benefits associated with internal financing. However, if a business opportunity pops up quite suddenly which you estimate could bring huge returns for your business, internal financing may not give you the flexibility you need to capitalise on that opportunity.

Internal finance vs external finance: Which one is right for your business?

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Based on the above, you may be thinking about whether you’re wanting to use internal or external sources of finance for business purposes. We should mention that you can actually use both in conjunction, and this could form part of a wider business plan that sees you diversify your sources of finance to give you a greater variety of investment options.

To recap, some key examples of internal sources of business finance are:

  • Retained profits.
  • Working capital (which could free up funds if you were to reduce the amount of working capital your business needs in a controlled way).
  • The sale of assets.

As for some closing thoughts, being able to generate enough profit to fund investments could well be a luxury for many businesses- especially for those who are not seeing huge profit margins under their current circumstances.

Perhaps the most important takeaway from discussions around internal vs external sources of finance is that you’ll likely need a solid cash flow forecast for the future, and a good plan of how to finance your business expansion, or survive in the short term, to make an informed decision about which financing option is best for your small business.

How could Esme help?

These are difficult times for many businesses, so it’s important now more than ever, to take good care of yourself and your team. If you’re concerned about your business being impacted financially due to coronavirus, visit our FAQ's page for information about how we may be able to support you.