What is external financing?

External financing is any way for a company to raise financing other than using its own money. This usually involves issuing equity in the company, such as selling shares. It can also include getting loans. As a general rule, increasing external funding costs more than internal funding.

There are two main ways a company can raise money. One of them is internal financing, which covers the money generated by the business, mainly its annual profits. Internal financing can also include some other methods, including the sale of a physical asset such as a building. The other way to raise money is external funding, which usually involves getting money from an external source without giving goods or services in return. Instead of giving up goods and services, a company that obtains external financing will often give up debt or equity.

Debt financing involves borrowing. This can be from investors rather than just a single bank. The best known way is through bonds, which are a promise to pay cash, plus interest, on a fixed date. Unlike most loans, a security can be sold to another investor, which means the company could end up repaying the money to someone other than the borrower.

Equity financing involves the sale of part of the company. This is also known as a fairness problem. In some cases, it is done through a private agreement with a specific investor. In other cases, it involves "going public" so that the company's shares can be traded on the stock exchange.

The first time a company does this is known as an Initial Public Offering. It's not a cheap option, as there are extremely complicated rules to follow when going public, especially about how the company explains its financial situation to potential shareholders. Following an initial public offering, future equity issues are known as a secondary equity offering. This could involve the company's owners selling some of their own shares or the company creating new shares to sell publicly. This last situation is called stock dilution, as it means that each shareholder holds a smaller proportion of the company.

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

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