Final answer:
Firms cannot solely use their profits for investment due to insufficient funds for significant expenditures, the need to maintain operational liquidity, and to avoid limiting growth opportunities. External financing options provide necessary funds, spread investment risks, and ensure stability.
Step-by-step explanation:
Firms can not simply rely on their own profits for financial capital due to various reasons. First, a firm’s profits might not be sufficient to cover large capital expenditures like machinery, new plants, or research and development projects. Moreover, relying exclusively on profits could jeopardize the firm's operational funds, affecting its ability to cover day-to-day expenses. Using only profits also limits the growth opportunities and financial flexibility of a firm as it confines the firm to invest only what it has internally generated, which could be inadequate for significant expansion or investment.
Additionally, external sources of capital such as early-stage investors, bank loans, bonds, and share capital can provide a firm with the necessary funds to invest in growth while maintaining their operational liquidity. Engaging with outside investors and lenders also spreads the risk associated with the investments. In times of low profits or losses, having access to external financial capital can be crucial for a firm's survival and continued investment in future profit-generating projects. Thus, outside investors and financial instruments like bonds and loans are essential for the sustained growth and stability of a firm.