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 –
- Long term Financing
- Short term Financing
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
- One of the most common external sources of finance is equity financing. Equity financing can’t be used by every company since there is a lot of legislation to adhere to. Thus, equity financing can only be used by big companies.
- To finance the requirement through equity financing, the companies go for initial public offerings (IPOs) where they sell the rights to own shares in lieu of money. As a result, when the company makes profits, the shareholders of these equity shares receive dividends if the company decides to payout.
- These shareholders can also sell their shares in the market and earn a decent profit when the stock price of that particular company goes up. IPOs help companies amass huge money and then they can use that money to expand their businesses or to invest in a new project.
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#2 – Debentures
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 –
| In US $ | |
| Revenue | 1,500,000 |
| (-) Cost of Goods Sold | (500,000) |
| Gross Margin | 1,000,000 |
| 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 –
| In US $ | |
| Revenue | 1,500,000 |
| (-) Cost of Goods Sold | (500,000) |
| Gross Margin | 1,000,000 |
| 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
- The term is a loan offered by a bank or a financial institution.
- In the case of the term loan, the company doesn’t need to issue debentures. But bank/financial institution goes through a thorough analysis of the company and then they offer a loan.
- Term loans are also secured by the assets of the company. If the company fails to pay off the money within a stipulated time, the assets are acquired by the bank/financial institution.
#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
source: Diana Shipping
- Preferred Stock is another long term external sources of finance. It has both the features of equity shares and the debt.
- Since these stocks are given preference over equity shareholders, they are called preference shareholders.
- They get the benefit of receiving the dividend even before the equity shareholders. If the company liquidates, preference shareholders are given preference over equity shareholders in dividends pay-out as well.
Short term financing
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.
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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 –
- What is Initial Public Offering(IPO)?
- How to Tackle a Venture Capital Interview?
- Top 5 Differences Between EBIT vs Operating Income
- Short-Term vs Long-Term Capital Gains
- Angel Investment vs Venture Capital Differences
- Internal vs External Financing
- Debt vs Equity Differences
- Debt vs Equity Financing
- Mezzanine Financing
