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
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.
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.