External Sources of Finance (Edexcel IGCSE Business): Revision Note

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 and 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

Factors affecting the choice of finance

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

Short-term and long-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