External sources of finance

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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].

Examples of External sources of finance

  • Bank Loan: Bank Loan is a type of external source of finance. It consists of a loan from a bank or other financial institution that is extended to a business. Bank loans may be used for a variety of purposes such as financing capital projects, purchasing inventory, or covering operating expenses. For example, a small business may take out a loan from a local bank to purchase new equipment.
  • Venture Capital: Venture capital is a type of external finance that is provided by venture capital firms or angel investors. Venture capital is typically provided to businesses that are in the early stages of development and can offer a high potential for return on investment. For example, a venture capital firm may provide funding to a startup business in exchange for an equity stake in the company.
  • Equity Financing: Equity financing is a type of external finance that involves the sale of shares in a business to investors. This type of financing is typically used by businesses that are looking to raise capital to finance growth or expansion. For example, a business may issue additional shares of stock to investors in exchange for capital that can be used to finance the business’s operations.

Advantages of External sources of finance

External sources of finance provide businesses with a variety of benefits. A few of the advantages of external sources of finance include:

  • Access to More Capital: One of the primary advantages of external sources of finance is that it gives businesses access to capital that they may not have had access to before. This can allow them to expand their operations and take advantage of opportunities that may have been out of their reach before.
  • Lower Cost of Capital: Another advantage of external sources of finance is that it can typically provide businesses with access to capital at a lower cost than internal sources of finance. This is due to the fact that external sources of finance generally come with lower interest rates.
  • Increased Liquidity: Another advantage of external sources of finance is that it can increase the liquidity of a business. This is because the capital provided by external sources can be used to pay off debts or provide additional working capital. This can also help a business to maintain its cash flow and remain competitive.

Limitations of External sources of finance

External sources of finance come with a few limitations. These include:

  • High cost: External sources of finance come with a higher cost of capital than internal sources of finance. This is because external sources are more risky than internal sources, and so lenders and investors charge higher interest rates and other fees.
  • Time consuming: Securing external financing can be time consuming and involve lengthy processes. The business needs to be able to provide documents and evidence of financial sustainability to demonstrate that it is capable of repaying the loan.
  • Loss of control: Taking on external financing may mean that the business has to give up some control over its operations to the lender or investor. This can include decisions related to the capital structure, financial strategy and operations.

Other approaches related to External sources of finance

External sources of finance refer to those sources of capital that come from sources outside the business. The most common approaches to external sources of finance are:

  • Bank Loans: Bank loans are a type of external finance that involves a business taking out a loan to cover expenses or capital investments. The loan is usually paid off over a specified period of time with interest.
  • Equity Funding: Equity funding involves taking on investors in exchange for a percentage of ownership in the business. This type of external finance is often sought by businesses that need a large amount of capital but don’t want to take on debt.
  • Government Grants: Government grants are a type of external finance available to businesses with certain goals. Grants are typically given out to businesses that are working on projects that the government deems to be of public benefit.
  • Angel Investors: Angel investors are wealthy individuals who invest in businesses in exchange for equity. They typically provide capital to start-up businesses or those that are in early-stage development.
  • Crowdfunding: Crowdfunding is a type of external finance that involves raising capital from a large group of people. Businesses typically use crowdfunding platforms to solicit investments from a wide range of investors.

In summary, external sources of finance refer to sources of capital that come from outside the business. Examples of external finance include bank loans, equity funding, government grants, angel investors, and crowdfunding.

Footnotes

  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.

References

Author: Michał Augustyński