External Source of Finance / Capital

The term ‘External Source of Finance / Capital’ itself suggests the very nature of finance/ capital. External sources of finance are equity capital, preferred stock, debentures, term loans, venture capital, leasing, hire purchase, trade credit, bank overdraft, factoring etc. By external sources, we mean the capital arranged from outside the business, unlike retained earnings which are internally generated out of the activity of business.

External sources of finance are those sources of finance which come from outside the business. For example, retained earnings are an internal source of finance whereas bank loan is an external source of finance. We can segregate external sources of funds between long-term sources of finance and short term sources of finance.

Long Term Sources of Finance

Equity Shares

Equity shares are a common source of finance for big companies. Not all the businesses can use this source as it is governed by a lot of legislations. A key feature of equity share is the ‘sharing of ownership rights’ and therefore, the current shareholders’ rights are diluted to some extent.

External Source of Finance /Capital

It is considered costly compared to debt finance because the return in the form of a dividend or bonus shares offered to shareholders is not tax deductible. Also, it’s not easy to raise this capital as it requires a lot of legal formalities to be complied with and above all, the investors should have faith in the company.

Debentures

Debentures are another common means of finance used by companies who prefer debt over the equity. Debt is considered to be the cheaper mode of finance compared to equity. It does not share control with investors. It is because the interest paid to debenture holders is tax deductible. Rest of process of debentures issue is similar to equity issue. It is offered to the common public and therefore necessary legislations need to be complied with. Debentures also involve some cost of issuing and they are collateralized by some assets of the company.

Term Loan

The characteristics of a term loan is very similar to debentures except that it does not include too much cost of issuing because it is given by some bank or financial institutions. The common public is not involved in it. A rigorous analysis of company’s financials and future plans is done by the bank to judge the debt servicing capacity of the company. These loans are also secured by some assets.

Preferred Stock

The preferred stock shares characteristics of both common equity stocks and debt. They are called preferred because they have got priority over common equity shares in terms of payment of dividend and the capital also at the time of liquidation. A special kind of preferred shares called cumulative preference shares has its dividend accumulated till it is not paid. The payment of such dividend can be delayed but cannot be ignored.

Venture Capital

It is same as equity shares except that the investors are a different set of people. Commonly known as venture capitalists, they normally invest in a new company at an initial stage and do a rigorous analysis of a company before investing. Venture capitalists exit the firm once it starts getting a good valuation.

Leasing and Hire Purchase

Choosing hire purchase or lease as an option over paying the full amount to the supplier of goods can help businesses delay its cash payment which is equal to having its goods financed. Normally, the hire purchase option is provided by suppliers of big machinery or bank becomes an intermediary at times. Both lease and hire purchase provide the buyer with an option to purchase the asset at the end of its term.

Short Term Sources of Finance

Bank Overdraft

Bank overdraft is a simple mode of short-term financing. Businesses need money for their day to day requirement which arises due to a time gap between their collections and payments. To fulfill such requirements, bank overdraft is an ideal short term source of finance.

Trade Credit

Trade credit is nothing but the credit given to a business by their creditors/ suppliers. It allows a business to delay its payments by some period. The period of credit depends on the credit terms between the business and the suppliers.

Factoring of Debt

It is an arrangement whereby the business sells its account receivables/ debtors at a discount. In this arrangement, the buyer, who is known as the factor, collects the money from the debtors on behalf of the business and charges a premium for this service. If the debtor does not pay for any reason, the factor can get back to the business for the payment.

Last updated on : August 31st, 2017
What’s your view on this? Share it in comments below.

One Response

  1. emma

Leave a Reply

Bonds and their Types
  • Lend And Borrow Keys Showing Borrowing Or Lending On The Interne
    Difference between Hire Purchase vs. Term Loan
  • .Credit Appraisal of Term Loans by Financial Institutions like Banks
    Credit Appraisal of Term Loans by Financial …
  • Convertible Debenture
    Convertible Debentures
  • Recourse & Non Recourse
    Recourse and Non-Recourse Factoring
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook


    Related pages


    debtor turnover ratio formulacost of common stock equity calculatorlc negotiation meaningebit formulafactoring in financial managementwacc debtsolvency and liquidity test formulanpv versus irrwhat is short term solvencymeaning of flotation costcapm aptcalculation for inventory turnoverformula for diluted epshedging definition financediscounted dividend model excelperpetual convertible bondpayment lc at sighthow to calculate a breakeven pointcar installment contractdividend growth valuation modelaverage investment in accounts receivable formulaaccounts receivable debtorspresent value interest factor calculatorroe formula financedefine double entry accounting systemequit definitioninventory turnoversdp meaning in financevaluation using dcfcapitalization vs depreciationwacc by industryhow to calculate the internal rate of returnfactoring finance definitionasset management ratio definitionadvantages of profitability indexliquidity quick ratiodupont roecapital budgeting techniques articlesdebt equity ratio calculation formulaconstant dividend growth model calculatorthe difference between stakeholders and shareholderswhat is debit and credit in hindihow to record bank overdraft in accountingtrade payables turnover ratiohypothecation of immovable propertyhow to calculate wacc from balance sheetis salary fixed or variable costdefine noiassumptions of capital structure theoriesmarginal costing formulamodigliani & millermaximisation definitionhow to record capital leasecapm vs waccdefinition of debit and credit in accounting termsmirr calculationprofitability ratios formula examplem&m proposition 1book debt to equity ratiodebt to value ratio calculatordupont model formulaequity holderassessing credit worthiness of a borrowersources of finance gcseshareholder equity formulacreditor days calculationadvantages of double entry system of accountinglocal bill discountingdebentures typesmaximize shareholder wealththe basics of capital budgetingdefine credit and debit in accountingwhy assets are debiteddebenture defintionwhat is operating lease and finance leasefixed asset utilizationirr timing problemadvantages and disadvantages of equity financingrecording notes payablefccb meaning