Definition
External sources of finance refer to the funds obtained outside of a business’s operations, typically from entities like banks, other financial institutions, or investors. These sources can include bank loans, grants, bonds, angel investors, or issuing shares. They provide necessary capital for businesses to grow, invest, or manage cash flow issues.
Key Takeaways
- External Sources of Finance refer to the funds raised outside the organization. It’s a method of obtaining capital from sources not internally generated within the firm, such as banks, other financial institutions, or investors.
- These sources often include debt financing through bank loans, equity financing from shareholders, and government grants. This method of funding can provide a substantial amount of money, particularly useful for startups or expanding businesses.
- However, the cost of external finance is often higher as it may involve interest repayments or giving up ownership stakes. Additionally, obtaining funds from external sources usually requires a rigorous application process and regular financial reporting.
Importance
External Sources of Finance are important because they provide businesses with additional funds that they may not be able to generate internally. This allows businesses to grow, innovate, and expand at a faster pace, and take advantage of opportunities that they wouldn’t be able to otherwise.
These external funds can come from various sources such as banks, investors, or creditors, who can offer different types of finance such as loans, equity, or credit. This not only broadens the financial base of the company but also reduces the financial risks associated with business operations.
The terms and conditions of these external sources are often flexible, allowing businesses to choose the most suitable option for their specific situation and needs. Without external sources of financing, many businesses would struggle to maintain sustainability and growth.
Explanation
External sources of finance play a crucial role in sustaining and growing business activities, especially when internal funds are insufficient or unavailable. Essentially used for scaling up operations, launching new ventures or products, or investing in equipment or technology, these external sources offer a financial inflow that helps fill in the investment requirements of businesses.
They provide a platform for businesses to expand without diluting existing operational funds, thereby maintaining a balance between growth and sustainability. Different forms of external finance come with their own benefits, costs, and obligations.
For instance, commercial loans can provide large amounts of capital, but they must be repaid with interest and can sometimes require collateral. Equity finance, on the other hand, reduces the direct liability as investors accept a share of profits rather than expecting regular repayments.
External finance can also come in the form of grants or subsidies for specific industries or sectors. Therefore, depending on their specific needs and possibilities, businesses can optimize the use of these diverse external financial sources to achieve their objectives.
Examples of External Sources of Finance
Bank Loans: One of the most commonly used external sources of finance is a bank loan. Businesses of all sizes often resort to taking out a loan which allows them to finance their operations, make large purchases, or even start a new business. This loan must be paid back over time with interest.
Selling Shares/ Equity Financing: This involves raising money by selling portions of their ownership or stock to investors. For instance, a company that goes public and conducts an initial public offering (IPO) is using external financing. It gives the company a huge influx of capital at the cost of sharing future profits.
Trade Credit: Some suppliers allow businesses to purchase goods or services and then pay the invoice at a later date. This is a form of short-term financing known as trade credit. It’s beneficial to companies that need to manage their cash flow in the short term, giving them time to sell their inventory and generate revenue before they have to pay for the inventory itself.
FAQs on External Sources of Finance
What are external sources of finance?
External sources of finance are funds that come from outside a business. These can include borrowing from banks, issuing shares, trade credits, and crowd funding among many others.
What are the different types of external sources of finance?
The main types of external finance include debt, equity, and trade finance. Debt finance involves borrowing money for repayment later, typically with interest. Equity finance involves selling parts of the business, known as shares, to investors. Trade finance means purchasing goods now and paying for them later.
What are the pros and cons of using external sources of finance?
Pros of using external financing include not needing to use up your own savings, being able to access large sums of money, and potentially gaining business expertise from investors. On the downside, it can lead to loss of control over the business, a legal obligation to repay with interests and increased pressure to perform well.
When should a company consider external sources of finance?
Companies should consider external sources of finance when they require significant capital expenditure, e.g. to expand their business, purchase new equipment, or invest in research and development. They can also seek external funding when they lack sufficient internal resources to fund their operations or to leverage the available opportunities.
How can external sources of finance influence a company’s financial position?
External sources of finance can significantly influence a company’s financial position. For instance, taking on debt could improve a company’s operations and returns if it leads to profitable investments. Conversely, excessive borrowing can lead to financial distress and possibly bankruptcy because of difficulties in servicing the debt.
Related Entrepreneurship Terms
- Equity Capital
- Term Loans
- Trade Credit
- Leasing
- Public Deposits
Sources for More Information
- Investopedia: A comprehensive online resource that offers explanations on various financial and investing terms, including external sources of finance.
- Accounting Tools: A detailed source that provides in-depth articles on finance and accounting topics, such as external sources of finance.
- Corporate Finance Institute (CFI): A professional training and certification provider that offers resources on a wide range of finance subjects, like external sources of finance.
- Financial Express: An online news portal that offers news, views and updates from the finance industry which can help understand practical applications of external sources of finance.
