external-sources-of-finance as

An introduction to external sources of finance

• In some cases, a business may not be able to fulfil its needs with internal sources of finance

  • Some projects or investments may require a significant amount of finance 

• An external source of finance is money that is introduced into the business from outside, such as a loan or share capital 

  • External sources, such as loans or issuing shares, can provide the necessary funds for these expensive projects

Examples of external sources of finance

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

  • Interest and fees to arrange financing 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

Loans

• A loan is a sum of money that is borrowed from a bank and repaid in instalments, with interest, over a specific period of time 

  • Loans can be short-term or long-term

  • Banks must approve the loan application

    • They usually require a detailed business plan and evidence of the ability to repay

  • Secured loans are more likely to be available to larger businesses and are typically repaid over five to 20 years

    • Interest rates may vary over the term of the loan, and terms may be renegotiated if needed

    • Failure to make repayments can mean a business has to convert non-current assets into cash (sell them)

  • Mortgages are long-term secured loans

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

    • Interest is payable, and assets are at risk if the business does not make repayments as planned 

Advantages and disadvantages of loans

Overdrafts

• An overdraft is an arrangement between a business and its bank to spend more money than the business has in its account 

  • A limit is agreed upon, and interest is charged only when a business “goes overdrawn”

  • It is 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

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

Advantages and disadvantages of overdrafts

Debt factoring

• Businesses can sell their accounts receivable (invoices) to a third party at a discount

  • The third party pays the business immediately, which means that cash is received immediately

  • Customers then pay the third party over the agreed time frame (possibly several months)

Advantages and disadvantages of debt factoring

Share capital

• Share capital is finance raised from the sale of shares in a limited company through flotation or a rights issue

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

• 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

Advantages and disadvantages of share capital

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

Advantages and disadvantages of venture capital

Crowdfunding

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

• 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

  • Investors are often attracted by incentives such as a sample 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

Advantages and disadvantages of crowdfunding

Evaluation of external sources of finance

• External finance can supply far more cash, right when it is needed, than a firm could ever save from retained profits

• However, external finance comes with additional costs and conditions, so a business needs to be confident future profits can comfortably cover them

  • Repayments with interest that must be paid

  • Investors gain a say in decisions

Advantages and disadvantages of using external sources of finance