EXTERNAL FINANCE: Meaning, Types, Importance & Examples

External Finance
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When starting a business, it’s important to think about how you’ll pay for the day-to-day costs of the business. You can get money from external sources of finance like family and friends, bank loans and overdrafts, venture capitalists and business angels, new partners, share issues, trade credit, leasing, hire-purchase, and government grants. We will look at the external sources of finance in this article for more understanding.

What Is Meant by External Finance?

When a business secures funding from sources outside of the company, they are engaging in “external finance.” The most common method of doing this is through the sale of stock. Borrowing money is another option. The cost of raising money from outside sources is typically higher than the cost of financing a project using funds already on hand. Getting money from people or organizations outside of your company is called getting “external” financing. Lines of credit at banks and other financial institutions count as well as money obtained from loans and investors in the form of stocks and shares.

External financing options can be more challenging to secure, but their larger size makes them worthwhile considerations when a substantial infusion of cash is required. Those choices are important for businesses that don’t have a lot of money lying around, but they also come into play when exploring new ideas, products, or businesses.

What Are the Main Types of External Finance?

The majority of start-up businesses rely on a combination of sources, including the founder’s personal savings and loans from family and friends. There are two primary types of external sources of financing: 

#1. Equity Financing, 

Equity financing is when money is given in exchange for a stake in the company and a share of future profits.

#2. Debt Financing,

In which money is borrowed and must be repaid with interest. Scholarships and grants are forms of financial aid that do not require repayment and may be offered by private foundations, government programs, or even for-profit businesses.

What Are Examples of External Sources of Finance?

It is important for businesses to have access to both internal and external sources of financing. Family and friends, bank loans and overdrafts, venture capitalists and business angels, new partners, share issues, trade credit, leasing, hire-purchase, and government grants are all examples of external methods of financing a business. 

#1. Loans From Banks

Bank loans are a common way for small businesses to obtain outside funding. The business applies for financing from a financial institution like a bank, savings, loan, or credit union. The application details the loan’s intended use, the sum sought, and the applicant’s business credit. The bank reviews the information, decides whether to grant the loan and sets the loan’s interest rate. If the company defaults on its loan obligations, the bank may seize any collateral it provided to secure repayment of the loan’s principal and interest.

#2. Bond  Issues

Small businesses that need debt financing have options beyond bank loans, such as issuing bonds. The Industrial Development Revenue Bond (IDRB) program helps businesses fund large industrial projects by partnering with local government agencies. After receiving IDRB approval, companies may issue bonds to the general public. The local development agency receives the principal and interest payments from the company and distributes them to the bondholders.

#3. Financed by Angels

Equity financing is an option for businesses that would rather not take on the risks associated with debt financing. The so-called “angel investor” is a type of equity financier. In exchange for a fraction of the target company’s equity, these investors help with things like equipment funding, marketing strategies, and industry expertise. To get their money back, angel investors want to back businesses with above-average returns (ROI).

#4. Venture Capital

Venture capital is another common type of equity financing. Investors in the venture capital industry seek out businesses with high growth potential and offer to fund those businesses in exchange for a large stake in the company. Many young businesses could benefit from the resources and guidance that venture capital firms provide. Because VC firms invest both money and knowledge, they frequently put their own industry veterans in charge of the companies they back.

#5. Friends and Family

 If you run a small business and are looking for small investments, a great place to start is with your friends and family. Getting a loan this way is exciting because there is no need to pay interest and the process is transparent. Since most of your friends and family members aren’t seasoned business investors, they may not be able to help you make sound decisions when it comes to creating an equity structure for your company.

What Are the External Financing Requirements?

#1. Internal Growth

The term “internal growth rate” is used to describe how fast a company can expand in-house rather than by taking on new debt. Therefore, it means that the company can reinvest its earnings and expand. However, ROI is determined by dividing net income by total assets. ROA is a measure of a company’s profitability and is computed as follows: Net income divided by total assets equals a return on assets.

#2. Sustainable Growth

A company’s sustainable growth rate is the fastest rate of expansion it can achieve without increasing its leverage or debt ratio. However, this indicates that the firm can maintain its current level of operations without raising capital on the capital markets or taking on additional debt. To determine the rate of growth that will not compromise the environment, we use the formula:

The ratio of Return on Equity to Retention Rate = Formula for Sustaining Growth

Why is External Finance Important?

In other words, external sources of financing are important because they help the company determine the precise amount of capital it will need to raise. In order to keep operations going, businesses must be aware of the extent to which they will require external financing. 

Financing coming from external sources can be used for a wide variety of purposes, including but not limited to: expediting growth, buying new equipment or property, smoothing out cash flow, releasing equity, funding marketing campaigns, restocking inventory, responding to emergencies, and much more.

The Advantages of External Financing

Consider the following advantages of external sources of finance:

#1. You’ll Be Able to Keep Your Resources Intact

Obtaining funding from outside sources means diverting funds from internal operations. It makes sense to put the company’s own money into an investment that yields a higher rate of return than the bank loan it has just secured and use the money it has raised from outside sources to run the business. Cash payments to suppliers can help your company’s credit score, so it’s a good idea to set some money aside from internal funds for that purpose.

#2. Expanding

One reason businesses seek outside financing is so they can undertake expansion projects they would otherwise be unable to afford. External financing can help you get the money you need to build an addition to your factory, for instance, if your company has expanded to the point where production capacity has outgrown your current location. Substantial investments in capital equipment necessary for expansion may be financed using external funding.

#3.  Knowledge and Experience Shared

Financing institutions often double as excellent resources for sound business advice. You can get advice on how to avoid pitfalls that have caused problems for other small businesses from your banker, for example, who has funded many other small businesses. An investor in your tech startup probably has some knowledge to contribute, and even if he doesn’t, he may know where to find some good resources.

Disadvantages of External Financing

Let’s look at the disadvantages of external sources of finance:

#1. Possession

If you’re looking for money from outside sources like investors or shareholders, you may have to give up some control of your business. The investor may provide the substantial infusion of capital you need to introduce your new product to the market, but they will also have a say in how the company is run. This can endanger the goals you set out to achieve when you established the company.

#2. Interest 

It is expected that investors will be compensated for their financial backing. Similarly to how banks charge interest on a loan, investors will expect a return on their investment. The cost of borrowing money will increase if you have to pay interest on it. However, it could make getting outside funding more difficult than you anticipated.

#3. It Requires a Lot of Effort

Trying to raise money from outside sources can feel like a full-time job in and of itself. You’ll need to do things like research possible funding options, write up a polished business plan, hone your pitch, and make a ton of phone calls to set up (or at least attempt to set up) in-person meetings with dozens of people. These activities also necessitate a considerable investment of time and means. There is no assurance that any of them will help you acquire the money you need.

What is Internal and External Finance?

Money raised from within an organization is known as an “internal source of finance.” Owners’ capital, retained earnings, and the sale of assets are just a few examples of internal financing options. It is important for businesses to have access to both internal and external sources of funding. However, family and friends, bank loans and overdrafts, venture capitalists and business angels, new partners, share issues, trade credit, leasing, hire purchase, and government grants are all examples of external methods a business can use to raise capital.

Internal Financing Examples

The sale of stock is the most typical internal source of financing. This is the cornerstone of your enterprise, the thing that customers buy from you in exchange for money. Internal financing also includes the practice of debt collection. For the most part, this is money owed for goods and services that were provided in the past, but payment for them may have been delayed. The sale of the company’s fixed assets is another important type of internal financing that can come in handy when more money is needed to support regular business operations.

External Sources of Finance Examples 

A line of credit or loan from a financial institution is a common form of external financing. When a company is first getting off the ground, this is often how they bring in its first significant sum of money, but it can be used at any stage. The sale of stock, which entices investors to invest in the company, is another common form of external financing.

Internal and External Sources of Finance Difference

The main difference between internal and external financing is where the money comes from. Internal financing comes from the business. It’s a type of self-sufficient funding. Investors from the outside, such as shareholders or lenders, provide funding through the provision of equity in the company.

Established businesses with stock or assets that can be liquidated may find it simpler to secure internal financing. However, for new and small businesses, an external financing source can be a lifeline in the form of a cash infusion. There’s no doubt that established businesses, due to their track record, may find it simpler to obtain financing from third parties.

FAQs

What is the best external source of finance?

Equity financing is one of the most common forms of financing obtained from outside sources…

What are the 2 types of financing sources?

The two most common kinds of financing are debt and equity investment. There is a possibility that certain aspects of a business could be financed by grants from the government.

What is the full meaning of finance?

The term “financing” refers to the method used to acquire money or capital for a financial outlay. Financial re-engineering refers to the practice of directing credit, loans, and invested capital to businesses that can best use the money.

References

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