External Sources of Finance

Define external source of finance.

External sources are sources of money from outside the business, from other people putting money into the business.

What are the main external sources of finance which are short term?

1. Trade credit
2. Overdrafts

What is trade credit?

Allows a business to obtain raw materials and stock but pay for them at a later date. The credit period is usually between 30 and 90 days.

What are the advantages of financing a business using trade credit?

- The credit period allows a company to make a payment after converting raw materials and stock into goods, selling them to its own consumers, and receiving payment.
- No interest is paid
- Easily available
- Discounts can be made available if money is paid early

What are the disadvantages of financing a business using trade credit?

- If payments are missed, it can lead to extra costs and poor relationships with suppliers. This may lead to difficulty accessing stock in the future.
- New businesses may also struggle to get credit with suppliers as they might not be trusted enough.
- Must be carefully managed to avoid over trading and cash flow problems.

What is an overdraft?

An agreement with the bank to allow available balance to go below zero when withdrawing money from a bank account.

What are the advantages of financing a business using overdrafts?

- A good way to cover short-term cash-flow problems
- A flexible source of finance because a business will use it only when needed and will only be used in emergencies.

What are the disadvantages of financing a business using overdrafts?

Overdrafts can become expensive due to the high interest rates charged by banks. In addition, the bank can demand full repayment within a short period of time.

What are the most common sources of medium-term finance for investment in capital assets?

1. Hire purchase
2. Leasing

What is hire purchase?

A business agrees to a contract to acquire an asset by paying an initial installment and repaying the balance of the price of the asset plus interest over a period of time.

What are the advantages of acquiring capital assets using hire purchase?

-Allows a business to spread the cost rather than use large sums of money by paying upfront, which new and smaller businesses may not have.
- Flexible, with terms from one to five years.
- Unlike leasing, once the final payment is made, the business owns the asset.

What is leasing?

Involves renting capital assets such as equipment and machinery instead of purchasing it.

What are the advantages of acquiring capital assets using leasing?

-It is cheaper in the short run than buying a piece of equipment outright.
- If technology is changing quickly or equipment wears out quickly, it can be regularly updated or replaced.
- Cash-flow management is easier because of regular payments.

What are the disadvantages of acquiring capital assets using leasing?

May be more expensive in the long term because the leasing company charges fees, which make the total cost greater than the original cost of the asset(s).

What are the most common external sources of finance to use for long-term business activities?

1. Bank loans
2. Mortgage
3. Share issue
4. Grants

What is a bank loan?

Money lent to a business that is repaid for a set period of time with interest. The interest rate is usually fixed.

What are the advantages of financing a business using a bank loan?

- Once accepted, the money will be accessible instantly in the business' bank account which will allow it take advantage of opportunities such as business growth.

- Banks can often also lend large amounts of money.

What are the disadvantages of financing a business using a bank loan?

- It is unlikely that any bank will provide loan finance to a new start-up unless security is offered. Security, if available, will very often come in the form of property. Therefore, this makes it more difficult for smaller business to get a bank loan.

- Interest charges on the loan increase business costs leading to increased expenditures and therefore a negative impact on cash-flow.

What is a mortgage?

Money provided by a bank or building society to help a business purchase a property.

What are the advantages of financing a business using a mortgage?

- Large sums of money can be obtained quickly to allow a business to expand and buy properties.
- Expenditure is easily managed because repayments are over a long period of time (usually 25 years or more).

What are the disadvantages of financing a business using a mortgage?

- Business costs are increased because interest is charged.
- If repayments are missed, the property can be taken from the business.

What is a share issue?

Money raised by a business through the sale of shares in the business.

Public Limited Companies sell shares on the stock exchange.

Private Limited Companies sell shares privately.

What are the advantages of financing a business using share issue?

Since shareholders cannot get a refund on their shares, if they wish to sell them, they must find someone else to sell them to. Therefore, share capital is a source of permanent capital.

What are the disadvantages of financing a business using share issue?

- Dividends has to be paid to shareholders.
- Buying shares gives the buyer part ownership of the business; owners are less in control of their business.

What is a government grant?

Money provided by the government to support a business.

What are the advantages of financing a business using a government grant?

- Large businesses can access large sums of money to help with expansion and investment in expensive fixed assets such as machinery or property.

- The money is usually free with no repayments needed.

What are the disadvantages of financing a business using a government grant?

Can be difficult to obtain particularly for small enterprises because there are strict criteria attached such as employing a certain number of people or staying in a location for a long period of time. Therefore, small business enterprises cannot guarantee the criteria will be met.

What is debt factoring?

Debt factoring is when a business sells its debts to a third party. This transaction allows businesses to get quick access to cash.

It is a short term source of finance.

What are the advantages of debt factoring?

- Receivables (amounts owed by customers) are turned into immediate cash.
- Business can focus on selling rather than collecting debts.
- There is no security required - unlike a loan or overdraft.

What are the disadvantages of debt factoring?

- Business doesn't receive 100% of the value of their debt.

What is micro finance? (Unlike to show up in exam)

When people are loaned very small amounts of money to start local businesses in order to become self sufficient.

What are the advantages of micro finance?

Benefits people who are unable to borrow money from the bank or provide security.

What are the disadvantages of micro finance?

- Only small amounts of finance can be borrowed.
- More common in underdeveloped countries.

What is debenture? (Unlikely to show up in exam)

A form of bond or long-term loan which is issued by the company. The debenture typically carries a fixed rate of interest over the course of the loan.

It is a long term source of finance.

What are the advantages of debentures?

- Good source of long term finance (15 to 25 years).
- Low interest rates compared to bank loans.
- Doesn't require security (collateral).

What are the disadvantages of debentures?

- Only available to limited companies.
- Interest must be paid every year and the full amount must be paid at the end of the term.

What is crowd funding?

Involves a large number of people investing small amounts of money in a business, usually online.

What are the advantages of crowd funding?

- It acts as a form of market research. If people don't invest, it means the business idea is not attractive or distinctive enough, indicating that the business is likely to fail.

- It provides opportunities for individuals to start up a business even if they don't have access to other sources of funding.

What are the disadvantages of crowd funding?

- Difficult to reach funding target.