Internal and External Sources of Funds
The business financing can be defined as the obtaining of resources or means of payment, which are used to the acquisition of capital assets that the company needs to achieve its objectives. Depending on their origin, funding or financial sources are grouped into internal and external funds. According to our text book, “On average, during the last 20 years corporations raised about 40 percent of their funds internally and 60 percent of their funds externally through the sale of new securities.” (Blocks & Danielsen, 2011).
Internal Source of Funds: These funds are generated by the company in the course of the business. For example:
- Contributions of the shareholders: It refers to the contributions of the members, at the time of legally establish society and through further contributions.
- Reinvested Earnings: This source is very common, especially in new firms, and in which the partners or shareholders decide that there will not be dividends in the early years, but these are invested in the organization.
- Depreciation and Amortization: These are transaction in which, and over time, companies recover the cost of investment.
- Increments of Accrued Liabilities: These are generated entirely in the company. Examples are the taxes that must be recognized monthly, regardless of payments, or pensions.
- Sale of Assets: These are the sales of the land, buildings, or disused machinery to cover financial needs.
- Reserves: Reserves are an extension of the permanent capital of the company, it has generic and even specific objectives against uncertainty or potential risks, but not yet known. Reserves ensure the expansion, especially when results in great difficulty for external financing of small and medium businesses with little access to capital markets, or in other cases, where the investment risk is too great to entrust to finance others, generating a high cost. (Small business ideas).
External sources of funds: These funds are outside the company, those funds provided by third parties such as:
- Suppliers: This is the most common source. This is generated by the acquisition or purchase of goods and services that the company uses for its operations in the short and long term. The credit amount is based on the demand for the good or service of the market. This funding source is necessary to analyze it carefully to determine the actual costs taking in consideration discounts for early payment, time of payment and conditions as well as the investigation of sales policies from different providers that exist in the market.
- Factoring: Consists of yielding to an intermediary (factor) the collection rights of the company’s customers, at a given price, taking care of their collection and taking a risk. The advantages are that it provides liquidity to the company and save it administrative recovery costs.
- Bank Loans: These are the major credit operation, which are offered by banks, and according to their qualifications are the short and long term.
- Commercial Discounts: The provider may ask us to accept bills of exchange, and discount these effects in a financial entity. In this way the provider receives an amount from the bank (which is less) and we pay when the amount specified in the letter to the bank is due. (Small business ideas).
The assistant professors of accounting at the school of business and management at Hong Kong University Chul W. Park, believes that “because of transactions costs and investor/manager information asymmetries, internally generated funds should be less costly than funds rose by issuing shares. This suggests that as firms use more internal funds relative to external equity, their costs of equity capital will fall and the rate the market uses to discount unexpected earnings of such firms will be lower.” (Park, 2000). I personally agree with this statement, however, most firms rely in external funds due the lack of internal funds, and in order to make profit, the internal funds depend on the external.