External financing: sources and types

According to the 9th Report on the Financing of SMEs in Spain, there are about 3.5 million SMEs in the country, of which some 34.8% have needed to resort to external financing. If we look at the data for SMEs with more than 10 employees, the percentage rises to 59.5%.

Nowadays, there are many sources of external financing that can be used to fund a company's activities. If you want to delve into the various options available today when it comes to external financing, then read on.

What is meant by ‘a source of external financing’?

An external source of financing means any economic resources that a company can secure from outside of the business, with the aim of investing it into that. In other words, banks, investors and other entities that lend money to businesses in order to expand their capital and, in turn, cover their needs. However, unlike internal sources of financing, which stem from the resources generated by the company itself, capital from external financing will normally be returned with interest to its issuer. 

According to the report cited above, most SMEs require external financing for current assets (67.5%), productive equipment (28.1%), real estate (11.2%) and innovation (2.7%). Just 0.6% of companies require external financing for national expansion plans, while 0.2% need it to expand internationally.

Classification of sources of external financing

Combining external and internal financing distribution ratios can be highly beneficial to the growth and performance of a company, but a business model with high external funding can prove risky. Currently, there is a wide variety of funding sources that companies can turn to. These are divided into two broad groups:

• According to repayment terms: the acquired debt is classified according to the time that elapses until all borrowed capital is repaid. This might be:
  • Short term: short-term sources of financing are those where a period of one year or less is set for the return of funds obtained. 
  • Long-term: when the repayment period is greater than one year, this is considered long-term financing, a.k.a. fixed asset financing. 
• According to origin: sources of funding can also be classified according to their origin. While internal sources are those stemming from a company's own capital, sometimes referred to as self-financing, external ones are those in which the funds come from outside of the company and, therefore, must be returned. 

6 examples of external financing

There are many ways to easily secure external capital. However, before opting for any of them, both the business model and the maximum amount to be financed must be taken into account, as well as the repayment terms, interest, processing period and risk, or any guarantees required. Below you will find several examples of external financing that companies regularly rely on.

Credit lines

According to the 9th Report on the Financing of SMEs in Spain, credit lines are still the go-to option for SMEs, with 20.5% of adherents. These work in a similar way to credit cards - there is a maximum limit of capital the company can access at any given time, and they can only access the amount they genuinely need. 

Credit lines are a source of external financing that come with fairly high interest rates. In exchange, they offer excellent flexibility to manage short-term liquidity problems, and as such tend to be used as a rolling fund for emergency situations. 

Bank loan

Meanwhile, 20.4% of SMEs continue to request bank loans to finance themselves externally. This is a well-known financial instrument if you're looking to start a new project, purchase new equipment to increase production, or secure increased working capital, among many other reasons. 

In this case, the bank lends the total amount agreed between the parties. The company will then have to pay back both the borrowed capital and the fixed interest rate on a monthly basis. However, it is possible to secure both short and long-term loans. 

Capital contributions made by partners or external investors

Although it may seem otherwise, there are certain forms of external financing that do not require the capital to be strictly repaid in full as in the previous examples. Contributions of initial or expansion capital on the part of partners or external investors allow a company's capital to be expanded without needing to get into debt.

However, the cost of capital from this source of external financing is not zero. In return, investors buying shares in a company expect to receive future returns from the profits generated. The distribution of profits is known as dividends, and although these aren't mandatory, they are necessary to maintain the trust of investors.

Leasing and renting

One of the most innovative means of external financing is leasing and renting. Both hail from the beginning of the 20th century, although they didn't become widespread until after 1960. This is a 'pay-as-you-go' model that can be applied, for example, to the purchase of machinery or vehicles. 

Specifically, they offer rental options in which a fee is paid for making use of material goods. With leasing you have the option to buy, which is sometimes compulsory, while with renting, you only pay instalments for the period in which you use the goods, which must be returned with no option to buy. Despite their differences, both options allow access to goods without having to pay for them in full. 

Factoring

Factoring allows companies to enjoy greater liquidity by making use of unpaid invoices stemming from long-term payment policies. With this mechanism, companies come to an agreement with financial entities for these to make advance payment of invoices in return for a commission.

Companies can thus ensure liquidity and cover their short-term payments without having to resort to other sources of external financing. Factoring, somewhat reduced by the pandemic, moved almost 89 billion euros last year in Spain alone.

Crowdfunding and crowdlending

Crowdfunding is another external financing model that has emerged in recent times. In this case, a collective network of financing for a given project is built through the internet, i.e., participants make a donation that allows the initiative to move forwards, in exchange for a future reward. 

On the other hand, with crowdlending, which is similar to crowdfunding, participants become investors and donations become loans, meaning that companies can secure various sources of capital from individual investors. However, the amount obtained will have to be returned with interest. Loans made through crowdfunding are set to reach some 48 billion USD in 2022.

As you can see in this article, obtaining capital from external financing sources is both normal and necessary for the proper functioning of companies. Striking a balance between internal and external financing, as well as choosing the most appropriate means according to the needs of each company, is crucial to ensure the performance desired. 

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