External Financing Dependence

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External Financing Dependence (EFD) refers to a measure of a firm’s use of Debt or equity issues to finance operations (or) investments. It can be defined as an indicator at the firm and industry level. The underlying idea concerning the EFD is that the External Financing Dependence is a firm-specific characteristic. This concept was introduced in the article “Financial Dependence and Growth” by Raghuram G. Rajan and Luigi Zingales in 1998[1]. Although that article has passed 20 years of the publication of Rajan and Zingales, this concept is still used in most of the updated articles. Rajan and Zingales (1998) showed the evidence that the degree of technological dependency external financing differs from sector to sector. It means that financially dependent industries can get the advantages of the potential growth opportunities presented by financial growth and development more than those industries requiring less external financing. Therefore, financial dependent development would result in differential rates of economic growth in different industries.Compared to the approach of Rajan and Zingales, calculating the external financing dependence at the firm level has the advantage of accounting for potentially large differences in the dependence on external finance within industries and size categories. (Mocking,2016). External Financing Dependence (EFD) is defined by the two-step process at the industrial level according to Rajan and Zingales (1998). First, a firm's EFD is derived by summing the firm's use of external finance (borrowings and equity issues, which equals total capital expenditure less cash flows from operations) and then divide it by the sum of capital expenditure over the period. Then, to summarize the EFD across all firms in an industry, the industry median is used. In equation, a firm’s external financing dependence is calculated as the difference between capital expenditures (CE) on cash flow (CF) from operations divided by capital expenditures (CE) by Rajan and Zingales (1998) as follows:[2]

          External Financing Dependence (EFD) ≡  Capital_expenditure (CE) – Cash_flow (CF)/(Capital Expenditure (CE))

In the Rajan and Zingales’ article “Financial Dependence and Growth”,the dependent variable is the average annual real growth rate of value, calculating by including the country characteristics and industry characteristics instead of indicator variables. This model is used to estimate the external financing dependence and economic growth in other research papers as follows;

      Growth in a industry of a country = β_(1….m).CountryCharacteristics + β_(1….m).IndustryCharacteristics+ β_(n+1..p).Characteristics  of country and industry) +β_(p+1)Interaction+ ϵ [3]

To calculate this formula, the country characteristic should include the GDP of the country, log of per capita income, average population and the measure of financial development (which is the sum of domestic credit and stock market capitalization to GDP). As for the industry characteristics, each industry’s dependence on the external financing is included. (Rajan &Zingales,1998).

External Financing Dependence (EFD) in Manufacturing Sectors

Rajan and Zingales (1998) classified manufacturing sectors according to the comparative rates of economic growth by sector in different countries, depending on levels of domestic economic development. This classification relied on a particular measure, the median firm’s External Financing Dependence (EFD), to reveal a technological characteristic of its sector. They then investigated whether international differences in the structure of growth by sector can be linked to differences in domestic financial development that make it easier to raise funds from the outside firm in some countries than in others. Rajan and Zingales (1998) assumed that there is a technological reason why some industries depend more on external finance than others. These technological differences persist across countries,so that an industry’s dependence on external funds is used as identified in the United States as a measure of its dependence in other countries.”

Related articles concerning External Financing Dependence (EFD) The followings are some of the updated articles that are used the concepts of Rajan and Zingales’ external financing dependence (EFD);

(1) Dependence on External Finance by Manufacturing Sector: Examining the Measure and its Properties by George M. Von Furstenberg (2007)

This article uses Rajan and Zingales’ way of obtaining representative values of External Financing Dependence (EFD) by sectors and of interpreting differences in these values as fundamental, and hence applicable to other countries, have been adopted in the studies seeking to show that sectors benefit unequally from a country’s level of economic development. The finding of this article is that EFD figures calculated from micro data do not match cyclically-adjusted aggregate estimates. There is no support for attributing fundamental features to U.S’s EFD values by industry that would justify applying them to other countries.

(2) Dependence on External Finance and SME Survival by Remco Mocking (2016)[4]

This article tests the firms that are the most dependent on external finance experience a stronger increase in ending rates than the group of firms that is the least dependent on external finance. In this article,the author uses the concepts of Rajan and Zingales’s theory. Rajan and Zingales (1998) study the relationship between finance and growth. It shows that industries that depend heavily on external finance grow faster in countries with more developed financial markets.

(3) External Financing Dependence and Corporate Saving in ASEAN5 by Xin Li (2020)[5]

This paper compares with many previous efforts such as “Financial Dependence and Growth” by Rajan and Zingales (1998) to explore the ideas of external financing dependence (EFD). In this article, the researcher uses this idea only. Rajan and Zingales argue that in a hypothesis that a firm can raise external funds equal to the optimal amount that fully reflects the technological characteristics of the industry. In contrast, in a less developed financial system, the amount of external financing raised by a firm can partly reflect the constrained access to external funds and thus is suboptimal. Following them, the article teststhe hypothesis that “industries that more important on external financing will have higher growth rates in countries that more developed financial system in 5 ASEAN countries”.

Advantages and Disadvantages of External Financing Dependence(EFD) If the firms (or) the industries (or) the countries choose the external financing dependence (EFD) for the economic growth, they have to consider the advantages, as well as, the disadvantages of EFD. Before setting out to securing the external financing, they need to understand the pros and cons of external financing such as Bank loans, investments from private individuals or investment firms, grants and selling company shares.

Advantages of External Financing Dependence (1) Preserving the Internal Resources- One of the advantages of external financing dependence is that EFD allows the firms to use internal financial resources for the firms. The EFD makes sense to preserve the own resources into that investment, using the external financing for business operations. The internal financial resources for cash payments to vendors will be set aside and this can make the firms for the growth.

(2) Economic Growth - Part of the reason that the firms use external financing dependence is that it allows to economic growth that the firms could not fund on their own. External financing dependence can also be used for making large capital equipment purchases to facilitate growth that the firms cannot afford on their own. As for the country level, the external financing dependence can help the economic development and growth of that country.

(3) Advice and Expertise- Firms (or) industry, even country willing to finance the business can get the useful sources of expert advice. Investing in the technology start-up likely has technology expertise to offer, and even if not, may be able to steer towards useful sources of advice. Technological dependency on external financing differs from sector to sector is one of the important advantages of the EFD.

Disadvantages of External Financing Dependence (1)Ownership and Partnership - Some sources of external financing, such as investors and shareholders, require to give up a portion of the ownership/ partnership in the company in exchange for the external financing. This can compromise the vision you originally had for the company.

(2) Interest- For the dependency of the external financing, the interest must be given for the external investment. Banks will add interest for the loan, and investors will ask interest return in the investment agreement. Interest of the external financing can be the large burden for the firms/ industry, even the country.

(3) Cash flow- The success of the firm depends on working capital. Because of the external financing, the cash flow can be affecting greatly. In the EFD equation, the cash flow is directly proportional to the external financing dependence. Therefore, the loss of working capital may make it impossible for a firm to continue operations without taking on more financing.


  1. {{cite journal|last1=Rajan |first1=Raghuram.G |last2=Zingales |first2=Luigi |title=Financial Dependence and Growth |date=1998 |
  2. Furstenberg,, Von George M; Kalckreuth, Ulf von (2006). "Dependence on External Finance: An Inherent Industry Characteristic?". Open Economies Review.{{cite journal}}: CS1 maint: extra punctuation (link)
  3. Rajan, R. G., & Zingales, L. (1996). Financial dependence and growth (No. w5758). National bureau of economic research.
  4. Mocking, R (2016). "Dependence on External Finance and SME Survival". CPB Background Document.
  5. Li, XIn. "External Financing Dependence and Coporate Saving in ASEAN". IMF Working Paper.

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