{"id":182257,"date":"2023-07-27T01:27:00","date_gmt":"2023-07-27T00:27:00","guid":{"rendered":"https:\/\/legalvision.co.uk\/?p=182257"},"modified":"2026-05-29T06:30:13","modified_gmt":"2026-05-29T05:30:13","slug":"external-internal-finance","status":"publish","type":"post","link":"https:\/\/legalvision.co.uk\/startups\/external-internal-finance\/","title":{"rendered":"What is the Difference Between External vs Internal Sources of Finance?"},"content":{"rendered":"\n<p class=\"wp-block-paragraph\"><a href=\"https:\/\/legalvision.co.uk\/startups\/funding-your-sme\/\" id=\"https:\/\/legalvision.co.uk\/startups\/funding-your-sme\/\">Internal financing<\/a> is a funding method that allows a company to deploy its own capital reserves, rather than seeking funds from outside investors or lenders, under the general principles of corporate financial management recognised across Australian, New Zealand and UK commercial practice. For startups, it typically means drawing on retained earnings or managing working capital more actively. Unlike equity financing, which the <em>Corporations Act 2001 <\/em>governs in Australia and ASIC oversees, internal financing carries no regulatory approval requirements, though it still carries a real cost of capital that founders often underestimate. This article will explain the difference between external and internal sources of financing so that you can ensure you are deploying your startup&#8217;s capital most efficiently.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">What is Internal Financing?<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">As the name suggests, internal financing refers to the funds available to the company without resorting to external sources. You can break down internal financing into long-term and short-term internal financing.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Long-term financing essentially describes your startup\u2019s retained earnings. This is all the aggregate profits your business has generated but has not been distributed to <a href=\"https:\/\/legalvision.co.uk\/corporations\/shareholders-rights\/\">shareholders<\/a> as dividends.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Short-term internal financing describes managing your working capital to allow you to repurpose the funds for certain purposes. In particular, you can change how you manage your credit controls, inventory levels and trade payables.&nbsp;<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">How Working Capital Management Releases Cash<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">Working capital is the cash tied up in your day-to-day operations. Managing it well can free up funds without needing to raise external capital.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">There are three main levers:<\/p>\n\n\n\n<ul class=\"wp-block-list\">\n<li><strong>Debtors:<\/strong> Invoice customers promptly and follow up on late payments. The faster clients pay, the more cash you have available.<\/li>\n\n\n\n<li><strong>Creditors: <\/strong>Negotiate longer payment terms with suppliers where possible. Paying on day 45 instead of day 14 keeps cash in your business longer.<\/li>\n\n\n\n<li><strong>Inventory: <\/strong>Avoid holding more stock than you need. Excess inventory ties up cash that could be deployed elsewhere.<\/li>\n<\/ul>\n\n\n\n<p class=\"wp-block-paragraph\">For early-stage startups with limited retained earnings, improving working capital management is often the most accessible form of internal financing. It does not require profits to exist. It simply requires tighter operational discipline around how cash moves through the business.<\/p>\n\n\n\n\n<a href=\"#content-next\"\n   class=\"block p-4 mt-10 text-xl font-bold text-center text-white no-underline bg-gray-800 rounded-t-xl\">\n    Continue reading this article below the form\n    <i class=\"text-xl fa-regular fa-arrow-down\"><\/i>\n<\/a>\n<div class=\"px-6 pt-10 pb-12 mb-10 text-center bg-gray-100 rounded-b-xl sm:px-12 test\">\n    <div class=\"mb-8 text-2xl font-bold text-orange\">\n        Need legal advice?\n        <br>\n        <span class=\"text-lg not-prose\">\n                            Call <a href=\"tel:+448081968584\" class=\"not-prose\">0808 196 8584<\/a> for urgent assistance.\n                <br>\n                Otherwise, complete this form, and we will contact you within one business day.\n                    <\/span>\n    <\/div>\n\n    \n\n<div class=\"not-prose flex justify-center text-left gform_input_bg_white    \">\n    <script>\nvar 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Internal financing refers to capital that is already in possession of your startup. You do not need to go to prospective <a href=\"https:\/\/legalvision.co.uk\/startups\/raise-finance-debt-equity\/\">equity or debt investors<\/a> to access the cash. Assuming you have adequate internal financing sources, internal financing is often preferable to external financing. This is because the authority to access the capital remains with your company.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">In turn, you do not need to worry about the dilution of shares in accessing internal financing as you would under equity financing. Nor do you need to incur onerous borrower obligations common under debt financing.&nbsp;&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">However, internal financing usually requires you to have adequate capital reserves in the form of retained earnings. Many startups, especially early-stage ones, lack ample reserves because they have yet to generate sales at a profit.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">External financing also has many of its own benefits. For example, investors often bring opportunities for your startup to establish industry connections and experience mentorship. Additionally, securing external financing can enhance the credibility of your business, and you may have avenues for starting partnerships. Most importantly, external financing alleviates the cash flow constraints on your business that may come with internal financing options. <\/p>\n\n\n    <div class=\"my-7 lg:my-10 border-y-2 border-gray-100 py-7 lg:py-10 flex flex-col sm:flex-row items-start gap-10\">\n                    <img decoding=\"async\" class=\"w-52 mx-auto my-0! rounded\" src=\"https:\/\/img.legalvision.com.au\/wp-content\/uploads\/sites\/4\/2022\/09\/06164254\/uk-startup-manual-290x410-1.jpg\" alt=\"Front page of publication\"\n                 loading=\"lazy\" width=\"208\" height=\"298\">\n                <section>\n            <div class=\"text-2xl font-bold\">UK Startup Manual<\/div>\n            <div class=\"body-text\">\n                <p>LegalVision&#8217;s Startup Manual is essential reading material for any startup founder looking to launch and grow a successful startup.<\/p>\n            <\/div>\n            \n\n<a href=\"https:\/\/go.legalvision.co.uk\/uk-startup-manual.html\" class=\" block px-5 py-3.5 max-w-fit bg-orange button__hover transition rounded text-white font-bold text-lg no-underline uppercase leading-tight text-center\" target=\"\" rel=\"\">Download Now<\/a>        <\/section>\n    <\/div>\n\n\n\n\n<h2 class=\"wp-block-heading\">What are the Disadvantages of Internal Financing?<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">A common misconception is that your internal sources of financing, particularly your retained earnings, are free sources of capital. That is not true.&nbsp;All businesses have obligations to return wealth to their investors.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If your startup has borrowed money in debt or <a href=\"https:\/\/legalvision.co.uk\/startups\/convertible-note\/\">convertible notes<\/a> that remain unconverted, you need to service the interest payments on the debt. This requires your startup to generate sufficient cash to meet these interest obligations.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Moreover, your shareholders expect compensation for their investment. Startup shareholder investors usually prefer to delay dividend payments in favour of the startup reinvesting available earnings into the company to grow its asset value. Nonetheless, there is a value your startup should place on its ability to generate sufficient earnings to reinvest back into the business.\u00a0<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">You can work out the minimum returns your startup must generate in cash flow to meet its interest payments and achieve sufficient capital growth (or distribute dividends, as the case may be). This figure is called your startup\u2019s weighted average cost of capital.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If your startup intends to draw on its retained earnings, it should be confident that the proceeds of these finances will exceed the weighted average cost of capital.&nbsp;<\/p>\n\n\n\n<div  class=\"box box--icon box--star\">\n    <!-- wp:heading {\"level\":3} -->\n<h3 class=\"wp-block-heading\">Case Study<\/h3>\n<!-- \/wp:heading --> <!-- wp:paragraph -->\n<p>Market conditions require your startup to achieve at least a 20% return on its investment to satisfy its weighted average cost of capital. This means that for every \u00a3100 you invest right now, it needs to generate the equivalent cash flow of \u00a3120 today.<\/p>\n<!-- \/wp:paragraph --> <!-- wp:paragraph -->\n<p>You believe that your startup can acquire a valuable piece of intellectual property for \u00a3100,000. Your startup\u2019s finance team runs the numbers and confirms that the intellectual property will generate a 25% discounted return on the initial investment over the next five years. Accordingly, this exceeds the minimum threshold of 20% you need to meet your weighted average cost of capital.<\/p>\n<p><!-- \/wp:paragraph --><\/p>\n<\/div>\n\n\n\n<h2 class=\"wp-block-heading\">Internal Financing and the Pecking Order Theory&nbsp;<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">Modern financial management theory argues that businesses should prioritise the following sources of capital in what is called the pecking order theory:<\/p>\n\n\n\n<ul class=\"wp-block-list\">\n<li>use <a href=\"https:\/\/legalvision.co.uk\/startups\/allocate-equity-startup\/\">retained earnings<\/a> where at all possible;<\/li>\n\n\n\n<li>if you do not have sufficient capital, you should use debt financing; and<\/li>\n\n\n\n<li>as a last resort, you should raise equity capital.&nbsp;<\/li>\n<\/ul>\n\n\n\n<p class=\"wp-block-paragraph\">However, the pecking order theory is less relevant for startups. This is because raising equity finance is the primary source of capital for businesses in their early stages of growth. An entire segment of the investment market is prepared to assume the relatively high risk of investing in startups in exchange for the potential upside of investing in a successful company.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Thus, while internal financing can be a great source of capital for your startup, financial management theories that prioritise internal financing may not capture the growth objectives of your startup.&nbsp;<\/p>\n\n\n\n<div  class=\"box box--icon box--info\">\n    <p dir=\"auto\"><strong>Key Statistics<\/strong><\/p>\n<ol dir=\"auto\">\n<li><strong>50%:<\/strong> Half of smaller UK businesses currently use external finance, with many relying on internal sources such as retained earnings.<\/li>\n<li><strong>86%:<\/strong> Eighty-six per cent of SMEs do not want to borrow, demonstrating a clear preference for internal financing.<\/li>\n<li><strong>\u00a37 billion:<\/strong> UK smaller business equity investment totalled \u00a37 billion in the first three quarters of 2025.<\/li>\n<\/ol>\n<p dir=\"auto\"><strong>Sources<\/strong><\/p>\n<ol dir=\"auto\">\n<li>British Business Bank \u2013 Small Business Finance Markets Report 2026 (March 2026)<\/li>\n<li>OECD \u2013 Financing SMEs and Entrepreneurs 2026 (March 2026)<\/li>\n<li>British Business Bank \u2013 Small Business Equity Tracker 2025 (June 2025)<\/li>\n<\/ol>\n<\/div>\n\n\n\n<h2 class=\"wp-block-heading\">Key Takeaways&nbsp;<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">Internal financing offers startups the advantage of using their own capital without diluting the existing shares or incurring onerous borrowing obligations. However, you must have adequate retained earnings to draw from to finance a project internally. Nor is internal financing a free source of capital. The return on the invested internal source of funds must exceed the required return on capital employed, just as it would using external financing. Finally, while more mature businesses tend to favour internal financing as a capital source of first resort, startups have different objectives. For these reasons, you may need to embrace external financing in the form of equity and hybrid financing.&nbsp;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">If you need help with your startup, LegalVision provides ongoing legal support for businesses through our fixed-fee legal membership. Our experienced <a href=\"https:\/\/legalvision.co.uk\/startup-lawyers-lp\/\" id=\"https:\/\/legalvision.co.uk\/startup-lawyers-lp\/\">startup lawyers<\/a> help businesses manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision\u2019s legal membership, call <a href=\"tel:+448081968584\" class=\"AVANSERnumber dynamic-number\">0808 196 8584<\/a> or <a href=\"https:\/\/legalvision.co.uk\/membership\/\" target=\"_blank\" rel=\"noreferrer noopener\">visit our membership page<\/a>.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Frequently Asked Questions<\/h2>\n\n\n\n<div class=\"schema-faq wp-block-yoast-faq-block\"><div class=\"schema-faq-section\" id=\"faq-question-1690417203501\"><h3 class=\"schema-faq-question\">What is the difference between internal and external financing for startups?\u00a0<\/h3> <p class=\"schema-faq-answer\">Internal financing refers to using the company&#8217;s existing capital, while external financing involves seeking funds from outside sources such as venture capital investors or lenders.<\/p> <\/div> <div class=\"schema-faq-section\" id=\"faq-question-1690417213816\"><h3 class=\"schema-faq-question\">What is the main advantage of internal financing for startups?\u00a0<\/h3> <p class=\"schema-faq-answer\">Internal financing allows startups to use their capital without diluting ownership or incurring borrower obligations, giving them greater control over their funding.<\/p> <\/div> <div class=\"schema-faq-section\" id=\"faq-question-1780032042700\"><h3 class=\"schema-faq-question\">What is the pecking order theory and does it apply to startups?<\/h3> <p class=\"schema-faq-answer\">The pecking order theory suggests businesses should use retained earnings first, then debt, then equity as a last resort. However, this is less relevant for startups, which often rely on equity financing as their primary capital source due to limited retained earnings in early growth stages.<\/p> <\/div> <div class=\"schema-faq-section\" id=\"faq-question-1780032055175\"><h3 class=\"schema-faq-question\">What is weighted average cost of capital?<\/h3> <p class=\"schema-faq-answer\">Weighted average cost of capital is the minimum return your startup must generate to meet its interest obligations and achieve sufficient capital growth for shareholders. Before drawing on retained earnings, you should be confident the returns from that investment will exceed this figure.<\/p> <\/div> <\/div>\n","protected":false},"excerpt":{"rendered":"<p>Internal financing is a funding method that allows a company to deploy its own capital reserves, rather than seeking funds from outside investors or lenders, under the general principles of corporate financial management recognised across Australian, New Zealand and UK commercial practice. For startups, it typically means drawing on retained earnings or managing working capital<a href=\"https:\/\/legalvision.co.uk\/startups\/external-internal-finance\/\">Continue reading <span class=\"sr-only\">&#8220;What is the Difference Between External vs Internal Sources of Finance?&#8221;<\/span><\/a><\/p>\n","protected":false},"author":13509,"featured_media":3255,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"_relevanssi_hide_post":"","_relevanssi_hide_content":"","_relevanssi_pin_for_all":"","_relevanssi_pin_keywords":"","_relevanssi_unpin_keywords":"","_relevanssi_related_keywords":"","_relevanssi_related_include_ids":"","_relevanssi_related_exclude_ids":"","_relevanssi_related_no_append":"","_relevanssi_related_not_related":"","_relevanssi_related_posts":"174704,2802,173832,175664,179937,182005","_relevanssi_noindex_reason":"","editor_notices":[],"footnotes":""},"categories":[31],"tags":[20,21,117,173,868],"class_list":["post-182257","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-startups","tag-small-business","tag-medium-business","tag-startup","tag-startup-business","tag-financing"],"acf":[],"yoast_head":"<!-- This site is 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