What is External Finance?

External finance is any way in which a company raises financing other than using its own money. This most commonly involves issuing equity in the company, such as selling stocks. It can also include taking out loans. As a general rule, raising external finance has a higher cost than internal financing.

There are two main ways for a firm to raise money. One is internal financing, which covers money generated by the business, most notably its annual profits. Internal financing can also include some other methods, including selling a physical asset such as a building. The other way of raising money is external financing, which usually involves getting cash from an outside source without giving goods or services in return. Instead of giving up goods and services, a firm getting external finance will usually give up either debt or equity.

Financing through debt involves taking out loans. This can be from investors rather than simply a single bank. The best known form is through bonds, which are a promise to repay the cash, plus interest, on a fixed date. Unlike most loans, a bond can be sold on to another investor, meaning the company may wind up repaying the cash to somebody other than who they borrowed it from.

Financing through equity involves selling a share of the company. This is also known as an equity issue. In some cases it is done by a private arrangement with a specified investor. In other cases it involves "going public" so that stock in the company can be publicly traded.

The first time this is done by a company is known as the Initial Public Offering. It is not a cheap option, as there are extremely complicated rules to follow when carrying out the IPO, most notably about the way the company explains its financial situation to potential stockholders. After carrying out an IPO, future equity issues are known as a secondary equity offering. This can either involve owners of the firm selling some of their own stock, or the firm creating new stock to sell publicly. The latter situation is referred to as diluting the stock as it means each stockholder now owns a smaller proportion of the company.

There are several aspects of doing business which are classed as external finance, even though they don't fit the pattern of a company going out and looking for it. For example, many firms negotiate deals where they have 30 days or more to pay for goods they buy such as raw materials. This effectively allows them to have the materials "free of charge" until the payment date, which counts as a form of finance.