Whether you're starting up or looking to grow your business, you won't get very far unless there's cash available. Finance, in the form of personal savings, loans and overdrafts, is essential for the purchase of labor and materials, to meet your operating expenses and to finance expansions. Businesses acquire long-term financing from two major sources. External finance comes from banks and other sources outside the company while internal finance is the cash you generate from inside the business.
The money you generate from inside the business is classified as an internal source of finance, and includes the owner's capital, retained profit, the sale of assets and debt collection.
External Versus Internal Sources of Finance
Businesses are faced with a seemingly endless list of options when it comes to financing their startup or growth ambitions – bank loans, overdrafts, angel investing, loans from family members, personal savings and shares issues to name just a few. All these sources fall into one of two categories: external or internal sources of finance. External sources of finance comprise the funds you raise from outside the company. Bank loans, overdrafts, credit cards and share issues are examples of external sources of finance. Internal finance is the cash you generate from inside the organization. The obvious example is cash from sales, but it also includes the owner's investment, the sale of assets and collecting on the company's debts.
Most entrepreneurs will invest at least some of their savings to get a business idea off the ground. In fact, it may be the only financing option for an early-stage business that does not yet have the credit history or revenues to support a loan application. The advantage of an owner's investment is that it's cheap money. Where the business is incorporated, the company will issue shares in return for the owner's cash. This benefits both parties: the company does not have to repay the investment, and the owner retains control over the business as the majority shareholder. Owner financing is not usually enough to get a business off the ground, but it is a good start.
Of all the internal finance examples, perhaps the most obvious is the company's profits. When you're making more money than you need to cover your operating expenses, you have the option of ring-fencing the excess and investing it back into the company. The beauty of retained-profit financing is the money is already yours, so you don't have to worry about debt obligations. However, it may be several years before you generate enough profit to cover major capital investments.
Retail businesses have the option of selling unsold inventory to raise much-needed finance. For example, you might sell a surplus of last season's fashions at a reduced price to raise cash very quickly – this also saves on storage costs. The thing to watch out for here is pricing: price too low and you risk losing profits from lower margins. Asset sales are another sales-related source of finance. Companies can raise money by selling the machinery or vehicles they no longer need. The market is much smaller for used business assets, however, and it may take some time to find a buyer.
If you have customers who do not pay on time (or at all), then collecting these debts is a relatively easy way to reduce the cash cycle and tap into existing sources of internal funds. Invoice factoring is a specialist finance service that pays you 80 percent of the invoice value upfront and collects the invoices for you. You get the balance of the invoice, less the factoring company's fees when the customer pays. Invoice factoring is an internal source of finance since it's not a loan – you're merely selling the invoices of the business. It's not a long-term solution, but for businesses with temporary cash flow problems, invoice factoring can help you raise money from the work you have completed much faster than waiting for a customer to pay on 30-or 60-day terms.