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Internal financing (internally generated financing) as a type of financing
External financing as a type of financing
The provision and repayment of the capital required for investments is a central issue in financial management. The field encompasses payment, information and control relationships between companies and their capital providers and, in the form of a detailed financial plan, is an indispensable part of every business plan. What options for raising capital exist in principle and how can the most suitable form of financing for a project be determined?
Types of financing
There is no universally valid formula for determining the optimal form of financing for an investment, as such a decision depends on numerous factors. Financing methods can fundamentally be divided by the source of funds into external and internal financing and by the legal status of the capital providers into equity financing and debt financing.
External financing includes the externally provided debt capital commonly known as loan financing in the form of a loan, as well as the externally obtained equity capital known as participation financing, where capital providers take a stake in the company.
As the counterpart to external financing, internal financing comprises all ways of raising equity and debt capital internally within the company. The provision of equity by the company itself is referred to as self-financing; internal debt capital can be generated, for example, through long-term provisions.
For private borrowers, the question is not typically whether financing is internal or external when funds are lacking. Instead, financing types are often classified, for example, as follows:
- Cash loan
- Installment loan
- Leasing with optional purchase
- Civil servant loan
- Overdraft
- Education loan
- Guarantee credit
Financing can also be distinguished according to, among other things:
- the type of repayment (e.g. balloon financing),
- the intended use (e.g. construction financing), and
- the form of disbursement (e.g. flash loan or cash loan)
Special forms also include the loan without Schufa entry and the loan despite negative Schufa.
Internal financing (internally generated financing) as a type of financing
If the company’s operating results show a correspondingly substantial surplus of funds generated by the production process over incurred expenses, the prerequisites for internal self-financing are generally met. This surplus of income is an essential criterion for a company's internal financing potential and is represented under the term cash flow as a key figure for company valuation.
An important way to increase the self-financed equity ratio is the use of subsidies, which can make up a substantial part of the investment volume, especially for technology-intensive innovations. Therefore, information about existing support programs should in any case be obtained before an investment or financing decision.
A special form of increasing company liquidity internally is so-called factoring. In this case, a receivable from a customer arising from the delivery of goods or provision of services is assigned by the company to a factoring company. This process, through which the receivable acquires the characteristics of equity, is referred to as the assignment of receivables. The value of the receivable is paid out by the factoring company to the assigning company less a factoring fee, which also takes into account the risk of a possible default on the receivable. Furthermore, the company has the option of assigning the receivable not to a factor but to purchasing companies specialized in assignments of receivables, which then securitize the receivable as a security and place it on the capital market.
Options for internal debt financing exist through financing from provisions or value adjustments of liabilities. Provisions reduce the annual surplus because the amount available for distribution is reduced by the provision amount. Since funds used to form provisions are bound to the company until their release, they can be used for financing. What matters here is always the term, because only long-term provisions have a sufficient financing effect. In particular, pension provisions are suitable for this form of financing due to their very long-term horizon. For reasons of maturity, purchases on credit, i.e. supplier loans, are only suitable for short-term interim financing at best, since the payment deadline—i.e. the date of the cash outflow—is usually too short to achieve an effective financing effect.
Furthermore, material values can be converted into liquid funds through reallocations in the asset area. However, in this process, known as refinancing, the total amount of available funds remains unchanged.
Financing by means of depreciation charges that do not involve cash outflows is one of the best-known forms of refinancing. Depreciation-related inflows have the character of non-occurring cash outflows, since the acquisition of the asset and the associated payment already took place in an earlier accounting period. Since these depreciation amounts are only needed for replacement investment at the end of the asset's useful life, they can be used in the meantime to finance other projects. However, this requires that the amounts corresponding to depreciation are available in the form of liquid funds.
External financing as a type of financing
With this type of financing, external funds are provided to the company that do not originate from its operational value creation process. If the funds provided lead to a legal participation of the capital provider in the company, they must be treated in the accounts as part of equity capital; in this case, it is referred to as equity or participation financing. This infusion can occur either by increasing the contributions of shareholders already involved in the company or by bringing in new shareholders who pay in their contribution.
A special case is so-called joint venture financing, in which external capital providers—either private individuals or entities or corporations specialized in this form of financing—appear as capital providers and take a participation in the company proportional to their contribution. The difference to a participation financing by shareholders is that the engagement of a joint venture capital provider is always time-limited. After achieving a satisfactory business result, the venture capital provider will seek to sell its shares at a profit.
Another special form of equity financing is so-called mezzanine financing (from Italian "mezzo" = half). In this case, capital providers are granted a share in the company's success but are not given any participation rights in corporate policy.
Since non-listed companies, such as a limited liability company or a limited partnership, do not have the option of quickly obtaining financed equity through the issuance of shares, longer-term forms of participation financing must be found and contractually agreed between investors and the company. In addition to equity financing, which always leads to the formation of equity, there is the possibility of providing debt capital to the company through external debt financing. This form of raising capital is commonly known in business and private sectors as loan financing. The borrower's compensation for the amount provided takes the form of interest payments. Because the interest to be paid is also intended by the capital provider to cover the risk of a possible failure to properly repay the loan, the level of interest always depends on the creditworthiness of the borrower as well as on the type and value of any collateral that may be available. Loans can be divided by term into long-term loans such as loans, obligations and bonds, and short-term loans such as supplier or customer credits, current account credits, discount credits or bills of exchange.
A special form of financing is leasing. Legally, a lease agreement is a contract for the transfer of the right to use an asset, which resembles a rental agreement. In contrast to renting, however, certain rights and obligations of a lessor—such as warranty claims or the obligation to maintain and service the leased item—are transferred to the lessee.
