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External Sources of Finance

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Business Studies

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?

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. None of the business owners put their money inside the business; rather, the money comes from external sources. If you were to have a business and you wanted to get some extra funds so you could expand, you could go to an external source of finance and get the money to help you develop. This could mean approaching a friend or family member, or going to a bank and taking out a loan.

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

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. You can use these sources to either establish a business or invest in a current and ongoing one.

Types of external sources of finance

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 types of external sources of finance include:

External Sources of Finance: 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.

External Sources of Finance: 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.

External Sources of Finance: 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.

External Sources of Finance: Overdrafts

Overdrafts occur when a firm or individual spends more money than they typically have available in their bank account.

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. A business is incapable of getting more money than the limit set by the lender.

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.

External Sources of Finance: 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.

External Sources of Finance: 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.

External Sources of Finance: 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.

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.

Disadvantages of external sources of finance

While there are many advantages of external sources of finance, they also come with some 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 require a portion of the company in order to provide funds for the business. 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.

External sources of finance - Key takeaways

  • External sources of finance include all the money coming from outside of a business.
  • 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.
  • The main types of external sources of finance include: family/friends, bank loans, mortgages, overdrafts, issuing shares, government grants, and 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.

External Sources of Finance

Money coming outside of the business owners for the purpose of financing.

Borrowing money from friends and family, taking a loan from a banks, issuing shares, etc.

The owner loses part of their business ownership. There is also the risk of not being able to pay back loans, in which case the bank could take your collateral.

External sources of finance are important for raising capital. When a business does not make enough profit to cover expenses or investments, it can turn to external sources of finance. External sources of finance may include bank loans, overdrafts or borrowing money from friends.

Internal sources of finance come from within the business. They may include the business owner's personal savings, retained profit or selling unwanted assets. On the other hand, external sources of finance come from outside of the business. The business may borrow money from friends and family, take out a bank loan or apply for a government grant to raise capital externally.

Final External Sources of Finance Quiz

Question

Define external sources of finance?

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Answer

External source of finance is all the money coming into a business from outside.

Show question

Question

Why are external sources helpful for individuals looking to open up a start-up?

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Answer

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.

Show question

Question

Can you get external funding when opening a start-up?

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Answer

Yes, it's one of the main ways to get the business going.

Show question

Question

Does borrowing money from your best friend count as external source of finance?

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Answer

Yes borrowing money from your friend counts as an external source of finance.

Show question

Question

Does taking a loan count as an external source of finance?

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Answer

Yes taking a loan counts as an external source of finance.

Show question

Question

What are the main types of external sources of finance?

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Answer

Main types of external sources of finance include: family/friends, bank loans, mortgages, overdrafts, issuing shares.

Show question

Question

Explain family and friends as a type of external financing source.

Show answer

Answer

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. It usually comes in the form of a loan that is set to be paid back with little interest or no interest at all.

Show question

Question

Explain bank loans as a type of external source of finance.

Show answer

Answer

Bank loans are one of the most common external sources of finance. Many people choose to take 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.

Show question

Question

Explain mortgages as a type of external source of finance.

Show answer

Answer

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. 

Show question

Question

Why mortgages are paid over a 30 year period.

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Answer

As they are loans for the purpose of financing land, buildings, offices, etc, they require large sums of money. Individuals need long time to pay these loans.

Show question

Question

Explain overdrafts as a type of external source of finance.

Show answer

Answer

Overdrafts occur when a firm or individual spend more money than they typically have available in their bank account. 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 to the limit agreed by the lender, usually the bank. 

Show question

Question

Explain issuing shares as a type of external source of finance.

Show answer

Answer

To raise money and provide financing, businesses may issue shares in return for money. It works by having companies offering parts of their business, known as shares, to other individuals, in return for money. 

Show question

Question

What are some advantages of external sources of finance?

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Answer

It enhances a company's growth.

It enables an individual to maintain their assets and use them for other purposes.

Show question

Question

How external financing enhances growth?

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Answer

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. 

Show question

Question

What are some of the disadvantages of external sources of finance?

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Answer

Being exposed to more risk.

Reduction in ownership.

Show question

Question

Define government grants as an external source of finance.

Show answer

Answer

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. 

Show question

Question

What is trade credit?

Show answer

Answer

Trade credit is also an important aspect of external financing. They usually apply 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.

Show question

Question

___ 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.

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Answer

Collateral

Show question

Question

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

Show answer

Answer

Mortgages

Show question

Question

___ occur when a firm or individual spends more money than they typically have available in their bank account.

Show answer

Answer

Overdrafts

Show question

Question

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

Show answer

Answer

Trade credit

Show question

Question

Someone who borrows money from the bank also has to pay ___ on top of the money borrowed. 


Show answer

Answer

interest 

Show question

Question

Overdraft indicates that the account balance is in ___ digits.

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Answer

negative 

Show question

Question

The purpose of ___ is to incentivize people to open new start-ups that help solve consumers' problems. 


Show answer

Answer

government grants 

Show question

Question

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

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Answer

True

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Question

Government grants are usually repaid.


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Answer

False

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Question

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


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Answer

suppliers 

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The people who buy these shares are known as...

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Answer

shareholders. 

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Question

In case the individual can't pay back the loan, the asset put as ___ is taken by the bank.

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Answer

collateral 

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Question

Which of these are external sources of finance?

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Answer

Bank loans

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