With the help of external sources of finance, companies can secure higher sums and thus invest in their growth. We show you here what all belongs to external financing and what advantages and disadvantages this method has.
Internal & external sources of finance explained
Internal and external sources of finance are the two ways in which companies finance themselves. In the standard case, they resort to a mix of both types.
Internal sources of finance
Internal sources of finance are financing options that the company can provide itself. The most important of these are revenues from operations, i.e. liquid funds generated from the sale of products or services.Another source is the sale of assets, for example production machinery that is no longer needed, vehicles or financial products such as shares or funds.
External sources of finance
External sources of finance are financing options that come from outside the company. These can be bank loans, venture capital from investors or capital acquired in exchange for company shares.
Although external sources of finance are associated with obligations of the company towards its financiers and thus the hurdles to obtain financing are higher, they often play a more important role than internal sources of finance. This is because business growth often requires large sums of money that cannot be financed from internal resources alone.
Examples of external sources of finance
A company wants to open another location and needs investment capital of £1,000,000. The internal sources of finance only provide capital of £300,000. This means that the company must obtain £700,000 from external sources of finance.
Its funding strategy then looks like this: It issues more shares to investors and applies for a bank loan of £500,000. Once it has raised enough money for financing through these measures, it can start opening the new site.
If, on the other hand, it had not received a bank loan or if the investors were not interested in further investments, the company would have to postpone the site opening to a later date or, in the worst case, would not be able to carry it out at all.
Both cases would inhibit the company's growth, which would mean that turnover could not be increased as planned and the company might even be at a disadvantage compared to its competitors.
External sources of finance: Advantages and disadvantages
Advantages
If companies resort to external sources of finance, they conserve their internal sources of finance and can use these funds elsewhere. For example, if the return on an investment in the capital market is higher than the interest on a bank loan, it makes sense to use the internal funds for financial investment and to take out a loan to finance further business.
Another advantage is that external financing methods can provide higher sums of money, enabling companies to invest in their growth more quickly. For example, as in the example above, they can quickly implement their investment projects without first having to save up sufficient equity capital.
Disadvantages
The disadvantage of external sources of finance is that companies lose part of their independence. In return for the provision of capital, investors and banks expect the company to develop in a certain direction.If the influence of external financiers is very high, they can even dictate the strategic goals of the company, so that directors can no longer decide independently on the future and direction of the company.
In addition, external sources of finance also come with financial obligations. Investors expect dividends or some other kind of profit sharing; bank loans often have to be paid back over many years, depending on the amount of the loan, which also entails interest charges.
External sources of finance for a small business
For small businesses, external sources of finance are important in order to grow. Start- ups often secure venture capital from investors. Small businesses that have been in the market for a long time and are well established are able to secure a bank loan for larger investments, provided they have a good credit score.
The simplest form of loan is an overdraft. This is suitable for smaller investments, as it does not have to be negotiated with the bank. The disadvantage is that high interest rates apply.
Another external source of finance for businesses of all kinds is crowdlending. Unlike banks, these have the advantage that investors who are more willing to take risks are more willing than banks to provide money, even if a company's credit score is not excellent.
FAQs
As such, external sources of finance could help to speed up your growth, acquire new equipment, purchase property, support uneven cash flow, release equity, fund marketing campaigns, replenish supplies, provide emergency relief and much more.
What are the advantages of external sources of funds? ›
As such, external sources of finance could help to speed up your growth, acquire new equipment, purchase property, support uneven cash flow, release equity, fund marketing campaigns, replenish supplies, provide emergency relief and much more.
What are the advantages and disadvantages of internal sources of finance? ›
The advantages of internal sources of finance are low costs, retention of control and ownership, no approvals needed, and no legal obligations. The disadvantages of internal sources of finance are the limited amount of finance and constricted number of options.
What are the advantages of sources of finance? ›
The advantages and disadvantages of the different sources of finance
| Source of finance | Advantages |
|---|
| Family and friends | low interest money may not need to be paid back |
| Bank loan | easy and quick to access can get a significant amount of money at one time |
| Overdraft | quick access allows emergency purchases |
10 more rowsExternal sources of finance refer to money that comes from outside a business. There are several external methods a business can use, including family and friends, bank loans and overdrafts, venture capitalists. and business angels, new partners, share issue, trade credit, leasing, hire purchase, and government grants.
What are the disadvantages of external sources? ›
One of the main disadvantages of external sources of finance is the risk the business is exposed to, especially when taking a loan. Businesses have to pay an interest cost for the loan they took out, which can be hard to pay back, resulting in loss of assets.
What are the disadvantages of external debt? ›
High levels of external debt can be risky, especially for developing economies. Among other things, it could increase the risk of default and being in another country's pocket, ruin credit ratings, leave little funds to invest and spur growth, and expose the borrower to exchange rate risk.
Which is better internal or external finance? ›
You do not need to go to prospective equity or debt investors to access the cash. Assuming you have adequate internal financing sources, internal financing is often preferable to external financing. This is because the authority to access the capital remains with your company.
Why is internal finance better than external? ›
Internal and external sources of finance compared
In short, internal finance is relatively easy to obtain and there is no direct cost of capital. Generally, however, there is a limit to how much internal capital a business can raise, especially in the short term.
What is the financial advantage disadvantage? ›
Financial advantage (disadvantage) refers to the incremental profit or loss, a company will earn in situations like acceptance of a special order, dropping off a business line, etc. It is calculated by only considering the relevant costs.
Advantage: Preserving Your Resources
One of the advantages of external funding is it allows you to use internal financial resources for other purposes.
What are the advantage and disadvantage of sources? ›
Advantages / disadvantages of information sources Source Books Primary journals Secondary journals Abstracts and indexes Reference lists & bibliographies Advantage Easy to access Scope for greater depth of coverage than journal overview Disadvantage Quickly out of date quality of indexing varies time consuming to ...
What are the disadvantages of long term sources of finance? ›
Long-term finance shifts risk to the providers because they have to bear the fluctuations in the probability of default and other changing conditions in financial markets, such as interest rate risk. Often providers require a premium as part of the compensation for the higher risk this type of financing implies.
What are the advantages of external borrowing? ›
External borrowing can be a valuable tool for countries looking to boost their economic growth. By borrowing money from foreign lenders, countries can access much-needed capital to invest in infrastructure projects, expand their economies, and create jobs for their citizens.
What are the two main categories of external finance? ›
Equity finance means you sell a share of your business, while debt finance means you borrow money from a lender who needs to be repaid.
Why are external sources of information important? ›
External data is used to help a company develop a better understanding of the world in which they are operating. Financial trends, customer demographics, online search queries, and more all help a company find the best ways to grow and reach its target market.
What is the most important source of external financing? ›
Most external financing comes from loans, with bonds and equities a distant second, except in the United States, where bonds provide about a third of external financing for nonfinancial companies.
What are the advantages of equity as a source of fund? ›
Advantages of Equity Financing
There are no repayment obligations. There is no additional financial burden. The company may gain access to savvy investors with expertise and connections. Company health can improve by decreasing debt-to-equity ratio and credit score.
