External sources of finance

From CEOpedia | Management online
External sources of finance
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Sanjay Bulaki Borad, the founder & CEO of eFinanceManagement, explains the external sources of finance as those sources of finance which come from outside the business. As external sources, we can understand the capital arranged from outside the business. For example, retained earnings are an internal source of finance where as bank loan is an external source of finance[1].

Types of external sources of finance

External sources of funds can be separated between long-term sources of finance and short-term sources of finance.

Short-term external sources of finance

* Equity shares /ordinary share capital, as a long-term source of finance, represents ownership capital securities and its ownersequity-holders/ordinary shareholders—share the reward and risk associated with the ownership of corporate enterprises. It is also called ordinary share capital in contrast with preference share capital which carries certain prior rights in regard to income and redemption[2].

* Debentures are a documents issued by the company. It is a certificate issued by the company under its seal acknowledging a debt. According to the Companies Act 1956,"debenture includes debenture stock, hands and any other securities of a company whether constituting a charge of the assets of the company or not[3].

* Short term loan Commercial banks also provide loans to the business concern to meet the short-term financial requirements. When a bank makes an advance in lump sum against some security it is termed as loan. Loan may be in the following form: cash credit, overdraft[4].

* Preferred stock is often referred to as a hybrid security because it has many character istics of both common stock and bonds. Preferred stock is similar to common stock in that it has no fixed maturity date, failure to pay dividends does not bring on bankruptcy, and dividends are not deductible for tax purposes. On the other hand, preferred stock is similar to bonds in that dividends are limited in amount[5].

* Venture Capital is a long-term financial assistance provided to projects, which are established to introduce new products, inventions, idea and technology. Venture capital finance is more suitable to risky oriented business which consists of huge investment and provides results after 5 to 7 year[6].

* Leasing and hire purchase is an accepted way of acquiring the use of fixed assets without incurring expenditure of the capital. Businesses realise that it is the use of the assets rather than ownership that would generate revenue for the business. Leasing is attractive for equipment which can easily become obsolete. Under a hire purchase contract, a hirer may terminate the hiring prematurely by returning the product. A financial lease does not allow the lessee to terminate the lease in this manner[7].

Long-term external sources of finance

* Bank overdraft is probably the most important source of fund for a very large number of small businesses. This is because bank overdrafts provide flexibility in uses and repayment. Bank overdraft provides flexibility because the amount by which a business goes overdrawn will depend on its needs at any point in time, and interest is only paid by the business when its account is in overdraft at a certain amount[8].

* Trade credit is a credit extended to a business (a small business) by trade credit suppliers who let the business (a small business) buy things now (products and services), and pay later. Any time a small business takes delivery of materials, equipment or other valuables without paying cash on the spot; the small business is using trade credit[9].

* Factoring in debt helps a small business will to factor its present and immediate cash needs. This usually involves specialist company (the factor) providing finance for unpaid invoices of the small business when it sells products (unpaid). These invoices will state the amount due. The invoice provides evidence of the sale and the money owed to the small firm. Hire purchase scheme is provided by many finance companies to purchase machinery or equipment[10].

Author: Michał Augustyński


  1. Sanjay Bulaki Borad, 2019, https://efinancemanagement.com/sources-of-finance/external-source-of-finance-capital , www.eFinanceManagement.com
  2. M.Y., Khan, P.K., Jain, (2007), Financial Management, Tata McGraw-Hill Education, New Delhi, India.
  3. The Companies Act (1956), Universal Law Publishing, New Delhi, India
  4. C. Paramasivan, T. Subramanian, (2009), Financial Management, New Age International.
  5. Keown, A.J., Martin, J.D., Petty, J.W., Scott, D.F. (2004) Foundations of Finance: The Logic and Practice of Financial Management, Pearson Education, China.
  6. C. Paramasivan, T. Subramanian, (2009), Financial Management, New Age International.
  7. Huat Tan C., (2001), Financing for Entrepreneurs and Businesses, NUS Press, Singapore.
  8. L. Ike (2018), Small Business: Start-Up and Management, Xlibris.
  9. L. Ike (2018), Small Business: Start-Up and Management, Xlibris.
  10. L. Ike (2018), Small Business: Start-Up and Management, Xlibris.