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2.1.2 External finance

A) Sources of finance:

  • Family and friends – Family and friends may be able to lend the business some money; however this is only likely to be suitable for sole traders. This is due to the fact that the money that friends and family will be able to loan the business will be limited.
  • Banks – This is the source of external finance that most businesses use. Large sums of money are able to be loaned from the bank, but it is likely to be much easier for bigger businesses such as PLC to lend money from banks than smaller businesses such as Sole traders. This is due to the fact that banks deem bigger businesses as less of a risk and therefore are willing to loan them money at a relatively low interest rate.
  • Peer-to-peer funding – This is when a business is able to take out a loan from a group of individuals or an institution. The loan will then be paid back after a certain amount of time. However, there is a risk to the borrower due to the fact that it is an unsecured loan. Therefore, they are only likely to lend to relatively established businesses.
  • Business angels – This is when a group of business experts invest in the business in exchange for a percentage share in the business. This can be beneficial to the business due to the fact that the investors are able to help the business in the decision making process. E.g. Dragons Den. This would usually be a source of finance used by businesses that are starting up.
  • Crowd funding – This is when individuals are able to invest in a business in return for a share of their business. This would usually be used by businesses that are starting up.
  • Other businesses – Business may get finance through other businesses that are looking to invest in the business in return for a percentage of their shares.

B) Methods of finance

  • Loans – Business may go to banks in order to raise finance for their business. This is likely to be a more suitable option for bigger businesses. This is due to the fact that it can be hard for smaller businesses to get a loan due to the fact that they are seen as more of a risk. This is in contrast to big businesses such as PLC’s and LTD’s which are already established in the market and therefore are able to get bigger loans at a much lower interest rate (economies of scale). Loans are likely to be used for big re investments in the business such as expansion where lots of funds are required. Interest will then have to be paid on top of the loan; however big businesses are likely to be able to pay a lower interest rate.
  • Share capital – Businesses may raise finance through selling some of their shares. This can raise a significant amount of money if the businesses is large, however, dividends will have to be paid to shareholders. This method of finance is only available to LTD’s and LTD’s. Although this is the case, the amount of shares that LTD’s will be able to sell will be limited due to the fact that they are only able to sell shares to friends and family. In addition to this, it means that the owners will have to give up a percentage of shares in their business. Only percentage of the businesses share are likely to be sold due to the fact that there is a risk of selling a high percentage of shares (above 50%) that someone will attempt to make an aggressive takeover of the business.
  • Venture capital – Businesses can also raise finance through venture capital. This is when venture capitalists invest in the business in return for a percentage of shares in the business in an attempt to make a high rate of return on their initial investment. This is usually a source of finance that is used by start-up businesses. Although it is a risky investment for venture capitalists, the potential for an above average rate of return is higher. Venture capital is often provided by business angels.
  • Overdrafts – Businesses may also take out overdrafts. This allows the business to go over their available cash balance. The overdraft limit is agreed by the bank. For example, a business may be able to go £2500 over their bank balance. This may be useful to a business in order to get through poor trading periods. Interest is charged on the overdraft which will need to be paid back by the business. The interest charge on the overdraft is usually at a higher rate than loans. Furthermore, there can also be big fines for a business if they go over the overdraft limit. Although an overdraft can be a good way of solving short term financial difficulties, it is not suitable as a permanent source of finance or for funding big investment projects such as expansion. An overdraft is suitable for all types of businesses but should only be used as a source of short term finance.
  • Leasing – This is when a business pays a sum of money in order to use a certain assert e.g. machinery for a period of time. This will save the money due to the fact that they do not have to spend money buying the asset. Although this is the case, the business will never own the asset. This source of finance is suitable for all types of business.
  • Trade credit – This is when a business receives the good e.g. stock but pays the suppliers at a later date. Therefore the business is able to sell the goods before paying the supplier. This source of finance is suitable for all types of business.
  • Grants – The business may obtain grants given to them by the government. For example, if the business locates in an area of high unemployment then they may be given a grant due to the fact that they will be employing staff thus bringing down the local unemployment figure. The benefit of this is that the business does not have to pay back the grant. However, they may have to meet certain requirements to receive the grant or the government may decide where it has to be spent. This source of finance is suitable for all types of businesses.
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