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

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

These categories of incoming funds are relevant for almost every organization. Depending on the scope of its activities, external financing and domestic financing is applied in various proportions. Sometimes it is enough to attract rather 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 financing and domestic financing?

Internal financing is the independent provision of all expenses for the development of a firm (using own revenues). Sources of similar receipts can be:

• The net profit received as a result of conducting financial and economic activities.
• Depreciation savings.
• Accounts payable.
• Reserve funds.
• Funds deferred to pay upcoming expenses.
• Income received for the future period.

An example of domestic financing is the investment of profits received in the purchase of additional equipment, the erection of a new building, shop 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 successful operation of the enterprise, its development and competitiveness is to correctly and effectively combine internal and external sources of financing. The ratio of own and attracted funds depends on the scope of the company, its size and strategic plans.

Types of financing

In addition to the division into two main groups, internal and external sources of financing are classified in more detail.

Internal:

• At the expense of net profit.
• Depreciation deductions.
• Sale of free assets.
• Income from the rental of property.

External:

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

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

What is internal financing?

Today, companies themselves are engaged in the distribution of profits, the value of which directly depends on how profitable the economic operations and effective divisive policy.

Proceeding from the fact that managers are interested in the most rational use of the funds that are available to them, they take care to take into account the most important factors:

• Implemented plans that provide for the further development of the company.
• The interests of owners, employees, investors were observed.

With a successful distribution of finance and expansion of the scope of the company's business, the need for additional financing is reduced. This shows the interrelation characterizing the internal and external sources of financing.

The goal of most business owners can be called the desire to reduce costs and increase profits no matter what type of funds will be used.

The positive and negative aspects of the use of own monetary resources

External financing and internal financing, as well as their effectiveness, are characterized by how easy it is for managers to use these types of funds.

The indisputable advantages of domestic financing, of course, is the lack of the need to pay the cost of attracting capital from outside. Also of great importance is the ability of owners to maintain control over the company's activities.

Among the shortcomings inherent in domestic financing, the most significant is the impossibility of its practical application. An example is the failure of depreciation funds. They almost completely lost their value due to a total decrease in depreciation rates at most domestic enterprises (in the industrial sector). Their amounts can not be used to purchase new fixed assets. The situation does not even save the introduction of the order of accelerated depreciation, since it can not be applied to the equipment that exists now.

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

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

Along with the obvious advantages of this approach (the possibility to increase the volume of economic activity or to develop new areas of the market), there is a need to repay borrowed funds and pay dividends to investors.

The search for foreign investors often becomes a "lifeblood" for many enterprises. However, with an increase in the share of such investments, the possibility of controlling the owners of enterprises is substantially reduced.

Credit and its specificity

Credits as an instrument of external financing become the most accessible way out for the owners of the company if the sources of internal financing prove to be untenable. External financing of the firm's budget should be enough to increase the volume of production, and also to return the attracted funds with accrued interest and dividends.

A loan is a sum of money that a lender gives to a borrower with a condition of repayment of the money and the agreed interest for the right to use this service.

Features of the use of loan funds to finance the company

Advantages of loans:

• The specificity of the credit form of financing is the relative independence of the borrower regarding the application of the amounts given to it (no additional conditions).
• Often, to get a loan, the owner of the firm applies to the bank that is engaged in servicing a particular enterprise, so the process of reviewing an application and issuing funds is quite quick.

Disadvantages of attracting loans:

• Often a loan is issued to the company for a short period (up to three years). If the firm's strategy provides for long-term profit, the pressure of credit commitments becomes too large.
• To receive funds on credit, the enterprise is obliged to provide a security equivalent to the desired amount.
• Sometimes the condition of lending 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 applied as rationally as possible and it is appropriate because the level of profitability of the enterprise and its attractiveness for investors depend on it.

Leasing: definition, conditions and characteristics

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

The terms of the leasing agreement are more liberal compared to lending, since they allow the business owner to expect a deferred payment and implement a large-scale project without major financial investments.

Leasing does not affect the balance of own and attracted funds, that is, does not violate the ratio characterizing 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 buying equipment under the terms of the lease agreement, the company has the right not to put it on balance during the whole period of the document's validity. Thus, the manager has the opportunity to save on taxes because the assets do not increase.

Conclusion

External financing and internal financing of enterprises involves the use of own revenues or borrowing from creditors, partners and investors.

For the successful operation of the company, it is very important to maintain an optimal ratio of these types of financing, as well as rational and justified expenditure of any resources.