External Financing

What is External Financing?

The most accurate external financing definition is that it’s money raised by a business from outside sources and not its own resources. This differs from internal financing, which is when a company funds its requirements from its own profits or an injection of money from the business owner.

Key Takeaways

External financing is money raised by a business from outside sources.
Businesses can use an external financing needed formula to establish what is required.
Credit cards, overdrafts, bank loans, and venture capitalist funding are external sources.
External financing is likely to be more expensive than internal financing.
A company can potentially grow faster if it agrees to take on external financing.

Why Consider Financing Options

Before we get into the various external vs. internal arguments, let’s start by looking at some of the reasons why a company may be considering its financing options.

The first option is a positive one: it wants to expand its business by developing new products or launching its services into a new market. Such ambitious growth plans require capital to turn them into reality and cover the costs of everything from higher staff wages to increasing inventory costs.

The second financing reason is when a company runs into trouble and needs a cash injection to keep the business afloat. Obviously, it’s more challenging to secure funding when the business is experiencing a challenging environment.

How External Financing Works

Anyone who wants to understand the external financing meaning will need to know how to find these outside sources of funding.

Before a business can start contemplating which form of financing will be most suitable, it needs to establish exactly how much is required. To help come up with this figure, we can consider the external financing needed formula. This can also be referred to as the EFN.

To find the external funds required, a business will need to take the expected increase in assets and subtract the subsequent increase in both liabilities and any retained earnings.

This is probably the simplest formula:

External Financing Needed = Increase in Assets – Increase in Liabilities – Retained Earnings

External Financing vs. Internal Financing

So, what do you need to consider when comparing external and internal sources of financing? Is one better than the other? How do they differ, and are there any similarities?

Here, we look at the key characteristics of each approach.

External Financing	Internal Financing
This is funding from sources outside of the business.	This is money coming from inside the organization, such as profits generated.
Sources include credit cards, bank overdrafts, loans, and venture capitalist funding.	Internal sources include retained earnings and money put in by the owner.
Can help the business expand by funding the costs of growing the business.	Can help the business expand by funding the costs of growing the business.
May be more complicated to arrange if it requires authorization from a bank.	Easier to arrange as the funds are already in the business.

Opinions Towards External Financing

Business leaders have different opinions of external financing. Those in favor believe it can fast-track growth. Those against it are concerned that it comes with a heavy debt burden.

For example, a study of 2,885 small and medium-sized enterprises by the UK’s Bank of England revealed half of respondents avoided external financing.

It stated: “The survey found a general theme of aversion to external finance, with around 70% of businesses preferring slower growth to having debt.”

Of the businesses that used external financing, credit cards were the most widely used source, while the use of non-bank equity finance or market-based debt was very limited.

External Financing Classification

Funding used by a business can be classified by its source.

For example, an internal classification means that the money has been generated from the company’s own capital. This is also referred to as self-financing.

However, funding that comes from a source outside of the business itself will be classified as external financing.

External Financing Examples

The good news for people who want external financing for their businesses is that there are plenty of options available:

Bank overdrafts
Bank loans
Peer-to-peer lending
Crowdfunding
Credit cards
Business angels and venture capitalists
Stock issuance

External Financing Pros and Cons

Let’s now move on to exploring the various pros and cons of external financing that are likely to influence a company’s funding decisions.

Pros

Enables a company to potentially grow faster
There are lots of banks and lending sources available
It enables the company to keep hold of its retained earnings
May also acquire input from experts as part of the deal, such as a venture capitalist

Cons

Taking on extra debt can be a significant longer-term burden
More complicated to arrange, depending on the source
Risk of growth plans failing and being unable to pay back the loan
Possible dilution of ownership if you have to issue shares

The Bottom Line

Anyone wanting to know the definition of external financing should understand it’s money raised by a business from outside sources. These can include credit card debt, bank overdrafts and loans, to investments from family members, business angels, and venture capitalists.

However, external financing can come at a cost. For example, this could be in terms of loans needing to be repaid or the dilution of ownership by issuing shares.

Therefore, any business owner who needs extra financing for his business needs to decide how much is required and the pros and cons of various sources before making a final decision.