External Sources of finance:
The choice of methods of financing is among the financial decisions taken by the management. One way of categorizing the sources of finance for business is to split them into internal and external sources. So, basically, the capital structure of every business is a mixture of internal and external sources of finance.
External sources of finance are all those sources that a business entity generates from outside the organization. There are various methods a business entity can use to raise finance from outsiders. However, we can classify these sources into long-term external sources or short-term external sources of finance.
In this article, we will discuss all the common external sources of finance, including long-term and short-term.
Funds are raised by issuing shares to the general public. The stock market can be used both as a market for issuing new shares for cash and as a secondary market where investors can buy or sell the company’s existing shares.
There are three principal methods of issuing new shares for cash:
- Issuing new shares of the company to the stock market for the first time. This is also called Initial Public Offer.
- Issuing new shares to a relatively small number of selected investors. This is called Placing.
- Issuing new shares to existing shareholders is a rights issue.
Shares are a common source of finance for big companies. In contrast, other business entities can not use this source as it requires compliance with regulatory authorities.
Debentures are also among the common external sources of finance. Debt finance is usually obtained by issuing bonds. Bonds may also be known as loan stock or debentures. Many companies choose debt finance over equity finance because debt is a cheaper mode of finance, and a company does not have to let go of ownership of the company.
Preference shares are also among the external sources of finance. However, preference shares might be called near-debt. They are neither debt finance nor equity. In financial reporting, preference shares are somewhat more likely to be shown in the statement of financial position as long-term liabilities instead of equity. However, this depends on the characteristics of shares.
Preference shareholders are entitled to receive dividends out of profits before ordinary shareholders. Moreover, in case the business goes into liquidation, preference shareholders standing before equity investors, but after suppliers of debt finance. Preference shares are a more expensive source of finance for companies than debt finance.
A venture capitalist is an individual or a group of investors who invest in business startups. However, they do an in-depth analysis of the business and realize the growth potential before investing. When the business performance improves, and it is going towards a stability phase, they choose the exit route.
Venture capital is generally offered by well-off investors, investment banks, and other financial institutions.
Business angels are wealthy people who assist entrepreneurs with their business idea by investing money. Their primary objective is the return on their investment. Their investment is usually less than the investment made by venture capitalists. Moreover, they make their own decisions relating to the investment.
Business angels can be affiliated or non-affiliated with your business. They include suppliers, customers, competitors, or any other individuals.
Long-term debt or long-term loan is another source of external finance. Financial institutions, most particularly banks, usually offer this type of debt to companies in return for interest over time.
There are certain conditions that companies fulfill before they are granted a long-term debt. Financial institutions go through an analysis of the financial status of the company, and then they might offer a loan. In most cases, long-term debt is secured by the assets of the company for the sake of security.
Banks offer a short-term facility to their loyal clients to finance their need for cash to meet payment obligations. A bank sets a limit to the amount of an overdraft that is allowed to the business entity. The advantage of a bank overdraft is that the borrower pays interest only on the amount of the overdraft balance.
Business entities avail bank overdraft facility for the following reasons:
- The overdraft is used to finance short-term cash deficits from operational activities.
- Bank overdrafts should only be used to finance fluctuating levels of cash shortfalls.
- An overdraft facility is for operational requirements and for paying running costs.
The bank normally has the right to call in an overdraft at any time and might do so if it believes the business entity is not managing its finances and cash flows well. A bank overdraft can therefore be a fairly risky type of borrowing for a business. Overdrafts are also expensive because the interest rate is comparatively high compared with other sources of finance.
Overdrafts can therefore be a high-risk source of finance, especially for businesses with cash flow difficulties. In other words, an overdraft is a great option for businesses that are usually in the greatest need of an overdraft.
Short-term bank loan
Business entities take short-term loans for specific purposes. A short-term loan is unsecured in nature because the amount of loan is small and paid within a short period of time. Unlike an overdraft facility, a bank loan is for a specific period, and there is a repayment schedule.
Business entities avail this type of loan from commercial and other banks on specific interest rates.
Hire purchase is an ideal source of finance for those business entities who wish to buy an asset without paying the full payment. The down payment is paid initially, while the remaining balance of the assets is paid in monthly installments over a period of time. Once the payment is complete, ownership of the asset transfers to the customer.