External Sources of Finance

External sources of finance definition

External sources of finance include all the money coming from outside of a business. Not many of the starting business owners put their money inside the business; more often, the money comes from external sources. This could mean approaching a friend or family member, or going to a bank and taking out a loan.

External sources of finance are very helpful for business owners, as it is often hard for them to secure the necessary investment to get the business going. There are a limited amount of assets one can invest in their own business.

External sources of finance make it easy for business owners to have the initial funds to open a start-up or get more money to expand. It is important to remember that external sources of finances are usually more expensive than internal sources.

External finance examples

There are many different potential investors that someone starting or developing a business can approach. Some might go to their friends or family members, whereas others may decide to go to a financial institution. The main external finance examples include:

• Family/friends

• Bank loans

• Mortgages

• Overdrafts

• Issuing shares

• Government grants

• Trade credit

Let's go through them one by one in more detail!

Family/Friends

This is one of the most common types of external sources of finance. Many business owners, especially new ones, resort to their family or friends to receive money for their business. The money usually comes in the form of a loan that is set to be paid back with little interest or no interest at all. Sometimes you might have friends or family members who simply gift you money for your new business.

Bank Loans

Bank loans are also one of the most common external sources of finance. Many people choose to take out a loan from a bank to invest in their business. Banks agree to lend money, and the individual has to pay this money back in instalments over the next years.

Someone who borrows money from the bank also has to pay interest on top of the money borrowed. This allows the bank to make a profit and continue its operations. The bank will monitor the person who applies for a loan and extend the loan when certain requirements are met. Additionally, banks could ask an individual for collateral.

This help banks mitigate risks and control for losses.

Mortgages

Mortgages often include large sums of money and are to be paid over a lengthy period of time, usually 30 years. This type of external source of finance is common when there are plans to expand or open a new business that requires land, factory, offices, etc.

Overdrafts

This indicates that the account balance is in negative digits, indicating that the bank is due money. The money that a business can get from overdrafts depends on the limit agreed upon by the lender, usually the bank. Overdraft is an external source of finance because the money comes directly from the bank.

The set limit is contingent on many factors, such as the business's revenue and the likelihood of paying the funds back. Overdrafts should only be utilized in extreme circumstances and only when necessary, since they may become very costly.

Issuing shares

To raise money and provide financing, businesses may issue shares in return for money. This works by having companies offer parts of their business - known as shares - to other individuals in return for money. This money can then be used to invest further and expand their entity.

The people who buy these shares are known as shareholders, and after having bought the shares, they are entitled to a part of the business. Companies benefit from issuing shares, as they can raise money without paying interest. However, this comes at the cost of giving some company ownership away.

Government grants

Government grants refer to money given by governments to new entrepreneurs. The purpose of government grants is to incentivize people to open new start-ups that help solve consumers' problems.

There are certain conditions that a new business has to meet to receive funds from the UK government. One of their main conditions is whether the business will create new jobs in the economy. Government grants are not usually repaid, and even if you had to pay them back, they don't come with interest payments.

Advantages of external sources of finance

One of the main advantages of external sources of finance is that it enhances a company's growth. One of the primary reasons businesses seek external capital is to support expansion initiatives that would otherwise be impossible for the firm to fund on its own.

Acquiring large capital equipment crucial to the firm's growth is almost impossible to get financed by internal sources. In this case, external sources of financing can be quite beneficial.

Getting large sums of money from outside sources allows companies to take advantage of opportunities as they arise. They do not have to wait a long time to gather enough capital from internal sources, rather they can invest and adapt their strategy immediately. This increases overall flexibility of the business.

Another benefit that comes with obtaining money through external sources is that it enables you to maintain your assets. You don't have to invest your assets more into the business, and you could use those resources for other endeavours. Alternatively, some assets give you a higher interest rate on your return than the interest rate paid on a bank loan.

This gives you the chance to put the money that you would otherwise have to put in the business into another more profitable investment, and use the money from the bank to cover your needs. Additionally, you may set aside internal financial resources for making cash payments to suppliers, which can assist in enhancing your company's credit rating.

The last advantage is that external sources is that they allow diversification of the risk by accessing multiple sources of capital. In that way, the company can reduce reliance on one source of funding.

Disadvantages of external sources of finance

While there are many advantages of external sources of finance, they also come with disadvantages, including the risk the business is exposed to, especially when taking a loan. Businesses incurring many losses will find it hard to pay the bank back.

Keep in mind that loans also come with the interest cost, and sometimes it is hard for businesses to keep up. This results in them losing the assets put forth as collateral and filing for bankruptcy.

Losing parts of the business' ownership is another disadvantage of external sources of finance. Some types of external financing, like share capital, require a portion of the company to be sold. This means giving up parts of the company's ownership.

Although you might get the money you need to expand, this comes at a cost. New owners might not share the same ideas with you, which might bring conflict in making decisions about the company's future.

Advantages and disadvantages of external sources of finance summary

The advantages and disadvantages of external sources of finance summary can be summarised in the table below: