External Sources of Finance

What is External Sources of Finance?

External source of finance is the one where the source of finance comes from outside the organization and is generally bifurcated into different categories where first is long-term, being shares, debentures, grants, bank loans; second is short term, being leasing, hire purchase; and the other is short-term, including bank overdraft, debt factoring, etc.

When a company needs a lot of money and its internal sources of Finance are exhausted, the company tries out the external options. If we talk about external sources of finance, there are two types –

External-Sources-of-Finance

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: External Sources of Finance (wallstreetmojo.com)

Long Term External Source of Finance

Under the long term External Source of Finance, companies fund their requirements by looking into options that are almost permanent and can offer them a huge amount in a go.

Below are the long term external sources of finance examples

#1 – Equity Financing

External sources of finance - equity financing

#2 – Debentures

External sources of finance - Debenture Financing 1

source: jabholco.com

Many companies choose debentures financing over equity financing; because debenture financing allows them to save on taxes. Here’s how it works –

ParticularsAmount (In US $)
Revenue1,500,000
(-) Cost of Goods SoldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more(500,000)
Gross Margin1,000,000
Labour(300,000)
General & Administrative Expenses(200,000)
Operating Income (EBIT)500,000
Interest expenses on debentures(150,000)
Profit before taxes (PBT)350,000
Tax Rate (25% of PBT)(87,500)
Net Income (Profit after taxes)262,500

Look at the taxes here. It is $87,500 because there are interest expenses on debentures of $150,000.

Now, if we don’t take the interest expenses into account, look at what happens –

ParticularsAmount (In US $)
Revenue1,500,000
(-) Cost of Goods SoldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more(500,000)
Gross Margin1,000,000
Labour(300,000)
General & Administrative Expenses(200,000)
Operating Income (EBIT) or PBT*500,000
Interest expenses on debentures
Profit before taxes (PBT)500,000
Tax Rate (25% of PBT)(125,000)
Net Income (Profit after taxes)375,000

As interest expenses are removed, the company needs to pay more taxes.

That’s why debenture financing is considered as cheaper sources of external financing. And also in debenture financing, the company doesn’t need to let go of ownership of the company.

#3 – Term loan

External sources of finance - Debenture Financing

#4 – Venture Capital

  • Many companies when they are at their starting stage take the help of venture capitalists.
  • Venture capitalists also do an intense analysis of the company and see the growth potential. And then if they feel satisfied, they invest in the company.
  • Once the company does well and the venture capitalists see that the valuation of the company has drastically been increased, they choose the exit route.

#5 – Preferred Stock

Preferred Dividends - Diana Shipping

source: Diana Shipping

Short term financing

External sources of finance - short term loan

source: Colgate SEC Filings

Sometimes, companies don’t need to borrow a lot of amounts. In that case, they can just take a little amount for a year or less and then repay back within the time. Let’s see the short term external sources of finance examples.

#1 – Bank Overdraft

  • When the companies need money for day to day activities they can take the help of a bank overdraft.
  • Bank overdraft is a sort of short term loan which can be paid off within a short period of time.

#2 – Short-Term Loan

  • Companies may take a short-term loan for their immediate needs from the bank.
  • Since the amount is small and the amount would be paid off within a short stint, the loan is unsecured in nature.

This has been a guide to what is external sources of Finance. Here we discuss the two types of external sources of finance long-term financing (equity, debentures, term loans, preferred stocks, venture capital) and short-term financing (bank overdraft and short-term loans). Here are the other recommended articles on Corporate Finance –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *