External Sources

External Sources of Finance

  • Trade Credit: This is when a business buys goods and services and pays for them later, typically 30-90 days. This is a popular method of short-term finance enabling businesses to manage their cash flow effectively.

  • Bank Overdraft: A flexible source of finance that allows businesses to withdraw more money than is in their bank account, up to a pre-agreed limit. Interest is typically charged on the overdrawn amount.

  • Bank Loans: Banks or other financial institutions lend a set amount of money, which the business must repay over an agreed time period, typically with interest. The loan could be for either a short term or a long term.

  • Hire Purchase: Allows companies to purchase an asset over time by making installment payments. Ownership of the asset is transferred to the company after the final payment is made.

  • Leasing: This allows businesses to use an asset without buying it outright. Payments are made over a period to the lessor (owner of the asset). The business does not become the owner by the end of the leasing period.

  • Government Grants: These are non-repayable funds provided by the government for specific purposes. Whilst they are a cheap source of finance, their availability is limited and subject to strict eligibility criteria.

  • Equity Finance (Issue of Shares): Limited companies can sell shares to external investors in return for capital. Each share sold represents a portion of the ownership of the company.

  • Debentures and Corporate Bonds: Long-term loans to the company by external investors. Debenture and bond holders receive periodic interest payments and the return of the principal amount at the end of the agreed term.

  • Venture Capital: External investors – often wealthy entrepreneurs known as ‘angel investors’, or venture capital firms – provide substantial sums of funding in return for a proportion of the shares.

  • Crowdfunding: A relatively new way of raising funds, typically by using online platforms to ask a large number of people to each invest a small amount in return for incentives such as shares, rewards, or equity.

  • Factoring: This refers to selling trade receivables (invoices) to a finance company in return for immediate cash. This service helps businesses to improve their liquidity but usually comes at a high cost.

Evaluating External Sources of Finance

  • Accessibility and Suitability: Not all external finance options are accessible by all businesses, due to factors such as size, creditworthiness and the purpose for which the finance is intended.

  • Cost: While some sources such as grants may be free, others could be more costly due to interest payments and fees.

  • Risk: Relying heavily on borrowed money can increase the business risk. If the business struggles to repay loans, this could lead to bankruptcy.

  • Control: Equity financing can dilute the control of existing shareholders, as new shareholders are brought into the business.

  • Impact on Cash Flow: Some financial sources such as bank loans or hire purchase require regular payments that may strain the business’s cash flow.