Advantages and Disadvantages Of External Sources of Funds

External sources of finance are from sources that are outside the business.

  Advantages of External Sources of Funds

  Outside investors expect the business to deliver value, helping you explore and execute growth ideas.

The right business angels and venture capitalists can bring valuable skills, contacts and experience to your business. They can also assist with strategy and key decision making.

Investors concern ; External investors always have a vested interest in the business’ success, i.e. its growth, profitability and increase in value.

 Refinancing; Investors are often prepared to provide follow-up funding as the business grows.

 Preserving your resources – external funding allows you to use internal financial resources for other purposes. If you can find an investment that has a higher return than the interest rate on the bank loan your company just secured, it makes sense to preserve your own resources and put your money into that investment, using the external financing for business operations. You can also set aside your internal financial resources for cash payments to vendors/suppliers, which can help improve your company’s credit rating.

  Growth – External funding allows firms to finance growth projects the company could not fund on its own. For example, external financing can help you get the funding you need to build a bigger manufacturing plant if demand for your product increases. External funding can also be used for making large capital equipment purchases to facilitate growth that the company cannot afford on its own.

 Greater Economies of Scale – Large businesses are generally more efficient than small ones. They have a greater bargaining power with suppliers and they can spread their fixed costs, such as administrative expenses, over larger sales. This results in lower costs per unit of production, which, in turn, gives the company a competitive edge in the marketplace. External sources of finance help a company grow faster, achieving the economies of scale necessary to compete with the rival firms on regional, national, or even international level.

 Leveraged Returns – External sources of finance also leverage the returns for the entrepreneur. If, for example, an entrepreneur starts a business with the return on investment rate of about 20 percent, providing $100k of her own money as the seeding capital, then, if no external sources of finance are used, her return should be about $20k (20 percent * $100k) a year. If, on the other hand, she takes a bank loan with an interest of 10 percent in the amount of another $100k, then the overall return from her business will be $200k * 20 percent = $40k, of which $10k will be the bank’s interest ($100k * 10 percent). The leveraged return our entrepreneur will get is, then, $30k.

Disadvantages of External Sources of Funds

  Loss of ownership – for a corporation, external financing may come from the issuance of new stock. This can decrease the owner’s equity and means a loss of ownership. Other business types may be forced to sell an interest in the business as a means of raising capital. Venture capitalists are often relied upon for external financing in exchange for a share in the business. The distinct disadvantage in ownership loss is the possibility of giving up untold shares of future profits for a bit of working capital in the present.

  Loss of Control – Debt based external financing normally means control of a company is secure. However, if a default were to take place, legal proceedings may force a loss of control if a judge appoints someone to oversee operations. Equity based financing almost always means a loss of control. Shareholders or other investors usually will have a vote or representation at annual meetings and can influence many corporate decisions. A company that relies too heavily on external financing may find itself being manipulated by outsiders. This loss of control is difficult to regain.

 Cost – The cost of external financing is a major factor. Debt financing has associated interest payments and a struggling company may be forced to accept high interest rates on a loan or be forced to issue bonds with a higher than anticipated interest rate. Equity financing can mean fewer future profits are kept within the company as investors and shareholders claim profits or dividends.

 Cash flow – The future of any company depends on the working capital. Cash flow can be greatly affected by external financing. Payments for principal and interest for debt financing or dividends for equity financing can limit a company’s ability to invest in expansion, research and development, marketing, or advertising. This loss of working capital may make it impossible for a company to continue operations without taking on more financing.

Thanks for reading this article. Have a fruitful day, won’t you!!!

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