The disadvantages of using internal sources of finance

Internal sources of financing, like cash drawn from a company's operating budget or capital income to fund a project or expansion, may be the simplest form of financing; this allows the company to make decisions quickly while avoiding the wait for financing approval and avoiding the cost of paying interest or dividends. However, this type of financing has important drawbacks that may mean that it is not always the best choice.

The chief concern with internal financing is that when you take money from your operating budget or capital, it leaves you with less money to manage daily expenses. In this way, using internal sources of financing for company endeavours can compete with budgets already in place. For this reason, internal investment is usually used to finance small projects and investments, where the costs are small, the payback quick, and the estimated returns significant.

When a company evaluates whether to use internal financing for something, it has to be able to estimate with reasonable accuracy the true costs of the project and provide an accurate forecast for recoupment of the investment. It also has to determine whether the return is adequate enough to justify the type of investment; the acceptable minimum level of return is referred to as the "hurdle rate." The accuracy of these calculations depends on how well the company is able to estimate its costs, predict trends and manage the budget outlined. When a company applies for external financing such as a loan, these calculations and figures are scrutinised because the creditor would stand to lose if the company later found it could not repay the debt; internal financing lacks this secondary "audit."

Further, there are other benefits of external financing that internal sources of financing don't have, such as the tax benefits of having external debt. The interest the company pays on external debt is tax deductible, as is the depreciation of any asset purchased. For this reason, the higher a company's tax rate, the more external financing or debt it is likely to have in its capital structure.

Moreover, internal financing is so easy that it leads to a lack of discipline. The company risks becoming inefficient or even complacent unless it strictly monitors the project's investment, budget and any increase in earnings that stems from the project. These actions would normally be required if the company took on debt, such as a loan, or used external financing like issuing stock.