External Finance Examples - Financial Business

External finance refers to funding obtained from sources outside of a business. It’s a vital tool for growth, expansion, and managing cash flow. Unlike internal finance, which uses retained earnings or asset sales, external finance introduces obligations to repay the funds, often with interest or other terms.

Examples of External Finance

Loans

Loans are a common form of external finance. Businesses can secure loans from banks, credit unions, or other financial institutions. These loans come in various forms:

Term Loans: These are loans with a fixed repayment schedule over a specific period. They are often used for purchasing equipment or financing projects. The interest rate can be fixed or variable.
Lines of Credit: A line of credit provides access to a pool of funds that a business can draw upon as needed, up to a specified limit. Interest is only charged on the amount borrowed. This is useful for managing short-term cash flow needs.
Mortgages: Specifically for real estate purchases, mortgages are secured loans using the property as collateral.
Small Business Administration (SBA) Loans: In the US, the SBA partners with lenders to provide loans to small businesses, often with more favorable terms than traditional loans.

Equity Financing

Equity financing involves selling a portion of ownership in the business in exchange for capital. This dilutes existing ownership but doesn’t create a debt obligation. Common types include:

Venture Capital: Venture capital firms invest in early-stage, high-growth potential companies. They typically take a significant equity stake and provide expertise and guidance.
Private Equity: Private equity firms invest in established businesses with the goal of improving their performance and eventually selling them for a profit.
Angel Investors: Angel investors are wealthy individuals who invest in startups, often providing seed funding or early-stage capital.
Initial Public Offering (IPO): An IPO involves selling shares of a company to the public for the first time, allowing the company to raise significant capital.

Debt Financing

Debt financing encompasses various methods of borrowing money that create a liability to be repaid.

Corporate Bonds: Large companies can issue bonds, which are essentially loans sold to investors. Investors receive interest payments, and the principal is repaid at maturity.
Commercial Paper: Short-term, unsecured promissory notes issued by large corporations to finance short-term liabilities such as payroll, accounts payable and inventory.
Leasing: Instead of purchasing assets, a business can lease them from a leasing company. This frees up capital and allows the business to use the asset without owning it.

Trade Credit

Trade credit is a form of short-term financing where suppliers allow businesses to purchase goods or services on credit, with payment due at a later date. This is a common way for businesses to manage their working capital.

Grants and Subsidies

Government agencies or private organizations may offer grants or subsidies to businesses that meet certain criteria. These funds are typically non-repayable and can be used for specific purposes, such as research and development or job creation.

Choosing the right type of external finance depends on several factors, including the business’s financial situation, its growth stage, and the purpose for which the funds are needed. Each option has its own advantages and disadvantages, which must be carefully considered before making a decision.