External Sources of Finance (Edexcel IGCSE Business)

Introduction to External Sources of Finance

• An external source of finance is money that is introduced into the business from outside 
  

  • External finance is used when a business cannot fulfil its needs with internal sources of finance

The main Sources of External Finance

• The implications of the different types of external finance need to be carefully considered

  • Interest and fees to arrange finance can vary significantly between financial providers

  • The percentage of company ownership required in exchange for finance depends on how much risk investors are willing to take

  • The length of time allowed to repay borrowings or achieve investment targets also varies
     

Overdrafts & Trade Credit

• An overdraft is a flexible arrangement for a business current account holder to spend more money than they have in their account
  

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

  • Overdraft users are typically charged interest at a daily rate

    • Using an overdraft for a long period can therefore be expensive compared to other methods
      
      

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

  • Some large businesses rely heavily on overdrafts to manage working capital
     

• Trade credit is where a business has an agreement to delay paying suppliers for a typical period of 30 to 90 days
  

  • This helps to improve the cash flow position of the business 
    

  • Trade credit is usually interest-free

  • Large businesses tend to be able to request more generous trade credit terms from suppliers than small businesses

  • Businesses using trade credit may miss out on early payment discounts

Finance from Loans

• A sum of money is borrowed from a bank or other financial provider and repaid with a fixed interest rate over a specific period of time 
  

  • The loan application must be approved before funds are transferred to the business

    • This may require a convincing business plan containing financial forecasts

    • Some financial providers demand collateral before a loan is granted
      

  • Long-term loans, known as mortgages, are used to fund the purchase of property

    • Repayment is typically over 25 or more years

    • Mortgages can have fixed or variable interest rates

Finance from Selling Shares

• A private limited company can raise finance by selling shares to friends, family or private investors such as business angels
  

• Public limited companies can raise large amounts of finance through the initial sale of shares during stock market flotation or through a rights issue
  

• Debentures are long-term loan certificates issued by limited companies to shareholders
  

  • Debentures must be repaid with a fixed rate of interest to lenders

Venture Capital

• Venture capital is sometimes available to businesses that are deemed too risky for other investors or lenders but are considered to have long-term growth potential
   

• It generally comes from specialist businesses and banks that look to maximise their return on investment

  • Venture capitalists may invest technological expertise, financial advice and management experience in return for a share in the business

  • Their investment is usually made for a fixed period of time, typically four to six years

Crowdfunding

• Crowdfunding allows businesses to access finance provided by a large number of small investors on online platforms such as Kickstarter and Fundable
  

  • Investments are voluntary donations that do not have to be repaid and do not attract a dividend

  • The business has to reach a target amount before any funds are released

    • They receive no funding if the investment target is not met by a set date
      

  • Crowdfunders do not own a share of the business

    • They are often attracted by incentives such as a sample or early access to a product 
      

  • Flow Hive is a beekeeping system that was successfully funded on Indiegogo in 2015

    • Its crowdfunding campaign raised $12.2 million from 38,470 backers

An Evaluation of External Sources of Finance

• Businesses must investigate and select a combination of sources of finance that are most appropriate for their particular needs
  

• A range of factors affect the suitability of sources of finance chosen by a business
  

Diagram: Factors Affecting the Choice of Finance

The choice of finance is affected by the timescale, cost and purpose of the finance, the legal structure of the business, willingness of owners to relinquish control and the level of existing debt

Timescale

• Short-term sources of finance will be needed to meet unexpected costs or to pay bills and suppliers

  • These are likely to be relatively small amounts and are rarely needed beyond a year

• Longer-term sources of finance will be needed to fund the purchase of non-current assets such as property and other types of capital equipment

  • These are likely to be large sums that may be required for a significant period of time
    

Diagram: Short-term & Long-term Sources of Finance

Long-term and short-term sources of finance

Legal structure

• Sole traders, partnerships and small private limited companies usually have a more limited range of sources of finance as they are seen as being a greater lending risk

  • Interest rates on loans are likely to be higher as these businesses tend to lend smaller amounts than public limited companies and are not in a position to approach specialist lenders
     

• Public limited companies are able to access a wide selection of sources of finance and are able to provide collatoral as security for lenders

 
Cost

• Interest payable on loans can add a significant cost to the use of some sources of finance
  

  • Variable interest rates change during the borrowing term, which may make financial planning difficult

  • Fixed interest rates remain constant for the duration of the loan and for this reason, they are usually higher than variable rates
     

• Selling shares in public limited companies is an expensive process

  • Flotation is usually carried out by merchant banks, which charge a premium for their specialist services

  • Selling shares through a rights issue may reduce the amount of share capital raised as they are usually sold at a discount to existing shareholders

 
Control

• Selling shares or raising venture capital can result in some loss of control for business owners
  

  • Smaller businesses may have to accept the terms of more powerful suppliers or business angels, as they have little power to negotiate  

 
Purpose of the finance

• Certain sources of finance have narrowly focused uses

  • A mortgage is the most appropriate type of lending to purchase property

  • Overdrafts are flexible and are best used for short-term working capital requirements

 
The level of existing debt

• Highly geared businesses already make use of significant amounts of debt

  • Lenders and investors may be reluctant to provide further funds due to the level of risk the business presents
    

• Businesses with a poor or no borrowing history may not meet credit score requirements and would be excluded from most types of credit