External Sources of Finance

So you want to open up a start-up, and you have some money to get your business going. You start your business, and then you find out that the money you had wasn't enough to get the business off the ground. What do you do? Do you go to a bank and take out a loan? Do you borrow money from your family or your best friend? Or do you find an investor and give them a share in your company in return for money?

External Sources of Finance External Sources of Finance

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Table of contents

    These are all examples of money that comes from outside of your business. This explanation will help you learn everything you need to know about 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 defined as funds coming from sources outside of the company, such as banks, investors, financial institutions, or other individual lenders.

    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.

    Collateral includes the assets of the business, and in case the individual can't pay back the loan, the asset put as collateral is taken by the bank.

    This help banks mitigate risks and control for losses.

    Mortgages

    Mortgages are a special type of loan that individuals take to buy tangible assets such as property, buildings, etc.

    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

    Overdrafts occur when a firm or individual spends more money than they typically have available in their bank account. An overdraft allows a company withdraw more money from its checking account than it has.

    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.

    Trade credit

    Trade credit is also an important aspect of external financing. This form of funding usually applies to a business that gets its goods from wholesale suppliers.

    Trade credit works by having the suppliers allow the business to pay for the goods later.

    This helps the business get going by driving initial sales and then paying the supplier later.

    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.

    Suppose your company is expanding to the point that you want extra production space to keep up with demand. In that case, external finance may assist you in obtaining the funds you require to construct the extension.

    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:

    AdvantagesDisadvantages
    Possibility to expand the business Higher interest costs
    Flexibility in business strategyDecreased control over the company (loss of ownership)
    Diversification of riskDebt obligations

    External sources of finance - Key takeaways

    • External sources of finance are defined as funds coming from sources outside of the company, such as banks, investors, financial institutions, or other individual lenders
    • External sources of finance make it easy for business owners to get the initial funds to open a start-up or get more money to expand.
    • Examples of external sources of finance include family/friends, bank loans, mortgages, overdrafts, issuing shares, government grants, or trade credits.
    • One of the main advantages of external sources of finance is that they enhance a company's growth.
    • One of the main disadvantages of external sources of finance is the risk the business is exposed to, especially when taking a loan.
    Frequently Asked Questions about External Sources of Finance

    What are external sources of finance?

    External sources of finance include all the money coming into a business from outside the firm.


    What are examples of external sources of finance?

    Borrowing money from family/friends, bank loans, mortgages, overdrafts, issuing shares, government grants, and trade credits are examples of external sources of finance. 

    What is the importance of external sources of finance?

    External sources of finance include all the money coming from outside of a business.  An external source of finance helps a business in its development. 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. 

    What are the disadvantages of external source of finance?

    One of the main disadvantages of external sources of finance is the risk the business is exposed to, especially when taking a loan.


    Businesses have to pay an interest cost for the loan they took out, which can be hard to pay back, resulting in loss of assets.


    Losing parts of the business' ownership is another disadvantage of external sources of finance.  

    What is the difference between internal and external sources of finance? 

    The term external sources of finance refers to money that comes from outside the business. This may include bank loans or mortgages, and so on. 


    Internal sources of finance include money raised internally, i.e. by the business or its owners, they do not include funds that are raised externally.

    Is trade credit an internal or external source of finance?

    Trade credit is an external source of finance because it usually comes from suppliers who are a third party from the perspective of a company.

    Is share capital an internal or external source of finance?

    Share capital is an external source of finance because it refers to funds raised by a company by issuing share stocks to investors. They, by buying shares, provide outside capital to the company in exchange for ownership in the form of stock.

    Test your knowledge with multiple choice flashcards

    Overdraft indicates that the account balance is in ___ digits.

    Raising finance internally results in losing parts of the business' ownership.

    Government grants are usually repaid.

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