Internal and External Sources of Business Finance Explained with Examples
In Commerce, understanding the "Sources of Finance" is essential for anyone studying business, management, or entrepreneurship. Every business—whether a startup, small enterprise, or large corporation—needs funds to operate, grow, and innovate. Finance, also known as funding, is the act of contributing resources to help a business, project, or necessity reach its goals. The way a business raises money can directly influence its future success and stability.
What are Sources of Finance?
Sources of finance refer to the different methods and avenues by which a company obtains the funds it needs for various purposes. These can be for short-term needs (like purchasing raw materials), medium-term goals (buying equipment), or long-term strategies (expanding into new markets).
The main sources are retained earnings, debt capital, and equity capital. Additionally, alternative methods such as crowdfunding and grants are gaining relevance, especially for modern startups and social enterprises.
Types of Finance: Major Categories
| Type | Description | Typical Use |
|---|---|---|
| Retained Earnings | Profits from business operations that are not distributed to shareholders, but reinvested for growth | Business expansion, new projects |
| Debt Capital | Funds borrowed from lenders (e.g., banks), or by issuing debt securities (bonds, debentures) | Asset purchase, working capital |
| Equity Capital | Raising funds by offering shares or ownership stakes in the company | Permanent capital for growth |
| Other Sources | Includes crowdfunding, grants, subsidies, and donations | Startups, nonprofit activities, sectoral support |
Key Principles and Examples
- Retained Earnings: When a business makes a profit, it can choose to reinvest some or all of these profits back into the company (instead of paying it all to shareholders as dividends). This helps in self-financing new projects or growth.
- Debt Capital: If a company borrows money from a bank at an agreed interest rate, it must repay the principal and interest as per the loan schedule. Another way is by issuing bonds or debentures to the public, promising fixed interest payments and principal repayment.
- Equity Capital: By issuing shares to new or existing investors, businesses can raise money without the obligation of repayment. However, the investors (shareholders) then share the future profits and have a say in some business decisions.
- Crowdfunding: Small businesses and startups may raise funds from a large number of small investors—often online—to support a new product, venture, or cause.
- Donations/Grants/Subsidies: Particularly relevant to nonprofits and organizations working for the public good, where funds are provided without expectation of a return. Grants and subsidies are often given by governments for specific initiatives—like research, education, or agriculture.
Step-by-Step Approach to Choosing a Source of Finance
- Assess the business need—Is funding for short-term operations, new assets, or long-term expansion?
- Evaluate available resources—Does the business have enough retained profits, or is external funding required?
- Compare costs and obligations—Debt requires repayment with interest, while equity dilutes ownership. Grants may not expect repayment but can have strict usage conditions.
- Consider business structure—Startups may benefit from crowdfunding; established companies can issue bonds or shares.
- Review market conditions and timing—Economic cycles, investor confidence, and regulatory environment affect funding options.
Definitions and Application
Debt vs. Equity Financing: Debt involves borrowing funds with a legal obligation for repayment. Equity involves exchanging ownership in return for capital, with no repayment obligation but sharing of future profits.
Formula Example: Business uses profit (Retained Earnings) = Net Income – Dividends Paid
If a company earns Rs. 5,00,000 and pays dividends worth Rs. 1,00,000, the retained earning used internally is Rs. 4,00,000 for expansion or other business needs.
Factors Affecting the Need for Finance
- Growth plans (launching new products, entering markets)
- Daily operational costs (salary, purchasing inventory)
- Capital structure, i.e., the balance between debt and equity
- Investment in research, technology, or acquiring assets
- Stage of business—startups may need more external capital; established firms can rely more on retained earnings
- Economic shocks or unexpected events (e.g., disaster recovery)
Comparing Major Sources at a Glance
| Source | Obligation to Repay | Ownership Dilution | Typical Cost |
|---|---|---|---|
| Debt | Yes | No | Interest expense |
| Equity | No | Yes | Share of profits (dividends) |
| Retained Earnings | No | No | Opportunity cost |
| Crowdfunding | Varies | Sometimes | Often platform fees or rewards |
Practice Question
A company wants to fund a new factory. It doesn't have enough retained earnings. Should it take a bank loan or consider issuing equity shares? Briefly explain the reasoning.
Next Steps and Learning Resources
To master this topic, revise related accounting and capital market resources. Practice analyzing real-world cases and apply the step-by-step approach detailed above for decision-making in business finance.
For more advanced lessons on accounting and financial management, explore relevant resources on Vedantu and strengthen your conceptual foundation in Commerce.
FAQs on Sources of Business Finance: Complete Guide for Students
1. What are the main sources of business finance?
The main sources of business finance are classified as internal and external sources. Internal sources include retained earnings and owner’s capital, while external sources cover equity shares, preference shares, debentures, loans from banks and financial institutions, public deposits, trade credit, leasing, factoring, and commercial paper. Each source varies in terms of cost, accessibility, and suitability for different business needs.
2. What is the difference between internal and external sources of finance?
Internal sources of finance are funds generated within the business, such as retained earnings and owner’s capital. External sources of finance involve funds sourced from outside the business, including shares, debentures, bank loans, and public deposits. The main differences involve origin, cost, risk, and repayment obligations.
3. What are internal sources of business finance?
Internal sources of business finance refer to funds generated by the business itself, without external borrowing.
Examples include:
- Retained earnings (profits not distributed as dividends)
- Owner’s personal savings or capital
- Depreciation funds
4. What are external sources of business finance?
External sources of business finance are funds secured from outside the business.
Key examples:
- Equity shares
- Preference shares
- Debentures
- Banks and financial institution loans
- Public deposits
- Trade credit
- Factoring
- Leasing
5. What are short-term and long-term sources of finance? Give examples.
Short-term sources of finance are repayable within one year and typically used for working capital needs. Examples: trade credit, bank overdraft, and commercial paper.
Long-term sources of finance are repayable over several years and used for capital investments. Examples: equity shares, debentures, term loans from banks and financial institutions.
6. What factors affect the choice of source of business finance?
Businesses must consider several factors when selecting a source of finance, including:
- Purpose and duration of funds required
- Cost of finance (interest, dividends, fees)
- Level of risk and security required
- Flexibility and ease of raising funds
- Control and ownership implications
- Current financial position and creditworthiness
7. List five sources of business finance with real-world examples.
Five sources of business finance and examples:
- Equity shares: Public companies like Tata Motors raise capital by issuing equity shares.
- Debentures: Reliance Industries issues debentures for long-term borrowing.
- Bank loans: Startups and SMEs secure working capital through commercial bank loans.
- Retained earnings: Infosys reinvests profits to expand operations.
- Trade credit: Retailers buy goods from suppliers with delayed payment terms.
8. Why is business finance important for entrepreneurs and companies?
Business finance is crucial because it enables companies to start, operate, and grow efficiently. Proper finance management helps businesses:
- Acquire necessary resources and assets
- Maintain adequate working capital
- Support expansion and innovation
- Meet obligations and manage risks
- Make strategic decisions regarding investments
9. What is the difference between owner’s funds and borrowed funds?
Owner’s funds are provided by business owners, such as equity capital and retained earnings, representing ownership interest. Borrowed funds are raised from external parties, like banks or the public, through loans, debentures, or public deposits, and must be repaid with interest or at maturity. Owner’s funds generally do not create repayment obligations, while borrowed funds do.
10. What is meant by retained earnings as a source of finance?
Retained earnings are profits that a company reinvests in the business instead of distributing them as dividends.
Features of retained earnings include:
- No additional cost or interest involved
- No dilution of ownership or control
- Promotes self-financed growth
11. Name three short-term sources of business finance.
Three short-term sources of business finance are:
- Trade credit
- Bank overdraft
- Commercial paper
12. How can a business decide which source of finance is most suitable?
A business can decide the most suitable source of finance by following these steps:
- Assess the amount and duration of funds required
- Analyze the cost and terms associated with each source
- Consider the business’s creditworthiness and financial structure
- Evaluate the risks, ownership dilution, and control factors
- Match the source to the specific business need (e.g., expansion, working capital)
