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A LevelBusinessEdexcelRevision Notes2. Managing Business Activities2.1 Raising FinanceExternal Finance

External Finance (Edexcel A Level Business) : Revision Note

Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

Updated on

Sources of external finance

  • External finance is sourced from outside of the business

Key sources of external finance

Diagram illustrating sources of external finance, including family and friends, banks, peer-to-peer lending, business angels, crowdfunding, and other businesses.
Sources of external finance include family and friends, banks, peer-to-peer funding, business angels, crowdfunding, and other businesses

 Family and friends

  • Small business owners approach close acquaintances to invest in or lend money to a business

Advantages and disadvantages of family and friends as a source of finance

Advantages

Disadvantages

  • Usually a very cheap source of funds

  • May have ‘no strings attached (e.g. a share of the business) and can be provided to the business on very flexible terms

  • Relationships may be damaged if the finance is not repaid

 

Banks

  • Banks provide several different kinds of loans to businesses, e.g. a small business loan

Advantages and disadvantages of bank loans

Advantages

Disadvantages

  • May offer both short term finance (e.g. overdrafts) and long term finance (e.g. loans or mortgages) if a business qualifies

  • Banks are often keen to provide free advice and guidance to businesses that use their services

  • Small sums may be borrowed from unsecured

  • A business plan is usually required to access bank finance

  • Banks can be cautious about lending to new, untested businesses

  • Interest (and often an arrangement fee) is payable

  • Businesses must be customers of the bank (i.e. hold a banking account) to access some loans

  • For larger amounts, businesses may need to provide security to be granted a loan

 

Peer-to-peer funding

  • Individuals with available savings pool it with others in a peer investment scheme such as Funding Circle

Advantages and disadvantages of peer-to-peer funding

Advantages

Disadvantages

  • Loans can usually be made available to businesses very quickly

  • Usually has ‘no strings attached (e.g. a share of the business)

  • Borrowers are charged a small fee to access finance in this way and have to pay interest in the same way as a bank loan

    • The individuals who made the money available in the first place receive some of this interest as compensation

Business angels

  • Some individuals specialise in making investments in start-up or expanding businesses e.g. Dragons Den investors

Advantages and disadvantages of business angels

Advantages

Disadvantages

  • Business angels tend to be more willing to take a risk than banks

  • Angels often offer advice and guidance to the businesses in which they invest

  • Investment is usually for a determined period of time so owners regain shares in the future

  • Finding the ‘right’ business angel (e.g. with appropriate experience, expertise or interest) can be challenging

    • Networking is vital when entrepreneurs seek this kind of investment

  • As business angels own a stake in the business, they may be involved in decision-making and will receive a share of business profits

Crowdfunding

  • Crowdfunding is finance provided by a large number of small investors on online platforms such as Kickstarter

Advantages and disadvantages of crowdfunding

Advantages

Disadvantages

  • Creates an organic customer base and the platform provides a form of free marketing

  • A good credit rating is not required so new businesses that lack a trading record can attract funding

  • Businesses need to provide a persuasive business plan to convince individuals to invest in their product as they will be competing with many other projects online

  • The potential for negative publicity if the project is not successful in attracting enough crowdfunding capital

  • Investors are often attracted by incentives

    • Examples of incentives include samples or early access to a product

      • E.g. In November 2022, well-known Twitter commentator Russ Jones published his long-awaited book funded via Unbound, a crowdfunding publisher

Other businesses

  • It may be possible for a business to access finance via a joint venture with another business, such as a key customer or supplier

  • Some large businesses buy shares in other companies as an investment or with the intention of a takeover

    • E.g in 2018, Mike Ashley, owner of Sports Direct, acquired a stake of just under 30% of Debenhams, a troubled British high street retailer, to eventually take over the company

Advantages and disadvantages of finance from other businesses

Advantages

Disadvantages

  • May provide access to business processes and market knowledge alongside finance

  • Can access large amounts of finance

  • Profits need to be shared between businesses

  • Decisions will usually need to be agreed by all businesses

Examiner Tips and Tricks

Recently, some sources of finance have been trickier to access. When assessing external sources of finance in your answers, acknowledge that businesses may find accessing these sources more challenging and expensive than in previous years. Many small to medium-sized businesses are often undercapitalised in their early stages. This has restricted their ability to grow.

Peer-to-peer lending, Crowdfunding and sources such as Business Angels have been able to fill some of the gaps left by changes in the banking industry. 

Recognising that a business may not be able to achieve its objectives due to an inability to borrow can be a useful evaluative point.

Methods of finance

  • Businesses have many different methods of finance available to help them achieve objectives

Key methods of external finance

Flowchart of finance methods: loans, leasing; share capital, trade credit; venture capital, grants; and overdrafts.
Several methods of finance are available to businesses, including loans, share capital, venture capital, overdrafts, leasing, trade credit and grants

Loans

  • A sum of money is borrowed and repaid (with interest) over a determined period of time

  • Bank loans are usually unsecured and are typically repaid over two to ten years

  • Mortgages are long-term secured loans

    • They are typically used by a business to purchase buildings, land or large items of capital equipment

  • Debentures are long-term agreements between a business and a lender to repay a specified amount (with a fixed rate of interest) by a certain date

    • Debenture holders are creditors rather than owners of a business and do not hold voting rights

Benefits and drawbacks of loans

Benefits

Drawbacks

  • Interest rates are fixed for the term of the loan

  • Repayments are made in equal instalments, helping budgeting

  • Businesses can purchase expensive equipment or property without the need for large amounts of capital

  • Control over decision-making is retained within the business

  • With debentures, interest is fixed, aiding budgeting

  • Interest rates depend on the businesses credit rating

  • Non-current liabilities are increased in the balance sheet

  • With a mortgage, missed payments may lead to property being repossessed

  • Failure to repay debentures may deter investors in the future

Overdrafts

  • An arrangement for business current account holders to spend more money than it has in their account 

  • A limit is agreed and interest is charged only when a business ‘goes overdrawn’

Benefits and drawbacks of overdrafts

Benefits

Drawbacks

  • A short-term source of finance that offers significant flexibility and aids cash flow

  • An overdraft may be ‘called in’ if the bank is concerned about a business's ability to repay what it owes

Share capital

  • Share capital is finance raised from the sale of shares in a limited company

  • Shareholders are the owners of shares and they are entitled to a share of the company’s profit when dividends are declared

Benefits and drawbacks of overdrafts

Benefits

Drawbacks

  • Large amounts of capital can be raised, especially by public limited companies

  • Interest is not payable on finance raised in this way

  • Shareholders usually have a vote at a company’s Annual General Meeting (AGM) where they can have a say in the composition of the Board of Directors

Venture capital

  • Funds provided by specialist investors in small to medium-sized businesses that have significant potential for growth, e.g. in the technology sector

Benefits and drawbacks of venture capital

Benefits

Drawbacks

  • Businesses that may have been refused finance from other sources may be able to attract investment from less risk-averse venture capitalists

  • Venture capitalists usually require a stake in the business in return for finance and often expect to exert some control over the business

Leasing

  • An asset such as a piece of machinery or a vehicle used by the business in return for regular payments

    • E.g. many businesses lease office equipment such as photocopiers and IT equipment

Benefits and drawbacks of leasing

Benefits

Drawbacks

  • The business does not own the asset during the period of the lease and so is not responsible for maintenance or repair costs

  • Leasing is usually more expensive in the long run than buying an asset

Trade credit

  • An agreement is made with suppliers to buy raw materials, components and stock which are paid for at a later date, typically 30 to 90 days later

Benefits and drawbacks of trade credit

Benefits

Drawbacks

  • Trade credit is usually interest-free

  • Discounts for early payment will not be available

Grants

  • Governments and industry trusts may offer grants to businesses that meet specific criteria

    • E.g. grants may be available for businesses that create jobs or improve infrastructure in a region

Benefits and drawbacks of grants

Benefits

Drawbacks

  • Grants do not need to be repaid

  • The business must use the finance for its intended purpose

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    Author
    Reviewer
    Lisa Eades

    Author: Lisa Eades

    Expertise: Business Content Creator

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

    Steve Vorster

    Reviewer: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.