What Is Operational External Financing? How Will Your Business Benefit?
Posted On June 4, 2022
Businesses need capital to operate and grow. Corporate financing is divided into internal and external financing depending on the origin of the capital. With external financing, money flows into the company from outside investors and lenders.
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The company does not use funds from sales or profits for investments. The external financing examples explained below consist of externally financed external financing, externally financed equity financing as well as special forms and mixed forms.
What is operational external financing?
External financing by definition means that internal or external financiers bring capital into the company from outside. Financial experts distinguish between these three different forms of corporate external financing:
Externally financed equity financing is also referred to as deposit financing or equity financing. The exact type of self-financing depends on the business type of the company:
- Stock corporations can go public for the first time or issue new shares
- Partnerships can include a partner or silent partner
- Sole proprietors can increase their equity
Equity financing gives investors the right to a share in the profits and a right to part of the assets and liquidation proceeds if the company is wound up. In addition, investors are entitled to business information. They have a say and can participate in operational decisions. In return, the financiers bear the business risk in whole or in part.
With debt financing, external lenders provide short-term, medium-term, or long-term capital for a company:
- Short-term and medium-term external financing: overdrafts, supplier credits, advance payments from customers
- Long-term external financing: bonds, promissory note loans, long-term loans
The term of short-term loans is less than one year. If repayment takes place within the next 1-5 years, it is medium-term financing by external investors. Long-term corporate financing has a term of more than five years. Special forms such as leasing as hire purchase of machines and other assets as well as factoring as the sale of open receivables with payment terms are also part of external financing for companies.
Mezzanine financing is a hybrid of debt and equity financing. The peculiarity of this form of external financing lies in the fact that a company receives equity capital or outside capital without granting the investor any rights of co-determination. The best-known examples of external financing as mezzanine financing are:
- convertible bonds
- bonds with warrants
- participation rights and participation certificates
- silent participations
- shareholder loan
- subordinated loans
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The Difference Between Internal and External Financing
The difference between internal and external financing lies in the origin of the capital. With internal financing, the money comes from the company itself, while with external financing, the capital comes from external investors.
As part of internal financing, the management forms reserves from the profits generated. The so-called retained earnings increase the company’s equity. Factoring has the same effect, although it is external financing. By selling open invoices, the vendor increases the equity ratio and at the same time reduces the balance sheet total.
The liquidation of hidden reserves is also part of operational internal financing. If a company makes provisions for impending losses and writes off fixed assets, this is also a form of internal financing. In addition, the sale of fixed assets and the reduction of inventory provides more capital from internal financing.
Advantages and disadvantages of external financing for companies
External financing provides companies with fresh capital that does not come from their own performance process. The money can be used to cover running costs or for investments. The various forms of external financing offer companies both advantages and disadvantages:
Benefits of External Financing
Large companies as well as small and medium-sized enterprises (SMEs) and start-ups can receive money from external investors. This is ensured by the various offers on the financial market. The funds available include government funding programs as well as loans from banks and private investors as part of crowd investing.
When company shares are issued, in some cases the investors bear part of the entrepreneurial risk. If the company suffers losses, investors may be required to make additional payments. This gives the company new capital and allows it to continue its operations or avoid bankruptcy.
If the shareholders increase their equity share, the higher equity ratio ensures a better credit rating for the company. Because of the better rating, banks, suppliers, and other financiers are more likely to grant a loan or offer financing on more favorable terms. Factoring has the same effect on the equity ratio, even if it is not self-financing.
Disadvantages of External Financing
In the case of external financing through loans, interest must be paid on the financing and repaid. There are regular loan installments that must be taken into account in the financial planning throughout the term.
The issuance of stocks and other company shares results in interest payments or dividends that may be due periodically. In some cases, the lenders are also given a say in business decisions. Going public is associated with costs and a lot of bureaucracy. This corporate financing is therefore only suitable for large companies.
Leasing and factoring also involve external corporate financing costs. However, the costs are fixed when the corresponding contracts are concluded and are lower compared to other types of financing. The factor has no say in business decisions. On request, the factoring provider assumes the default risk of the outstanding receivables and thus ensures stable liquidity for the creditor.