Unit 2: Finance – External Sources of Finance
Welcome to your study notes on External Sources of Finance! Whether you are aiming for top marks or just trying to get your head around the basics, these notes will guide you through everything step-by-step.
Every business needs money (known as capital) to start up, run day-to-day operations, or expand. When a business cannot generate enough money from inside the business, it must look outside. In this chapter, you will learn about the different ways businesses get money from outside sources, when to use them, and the pros and cons of each.
1. What is External Finance?
External finance is money obtained from individuals, banks, or other institutions outside the business.
Businesses classify external finance into two main categories depending on how long they have to pay it back:
• Short-Term Finance: Money borrowed or owed that must be repaid within one year. This is usually used for everyday expenses like paying electric bills, wages, or buying stock.
• Long-Term Finance: Money borrowed or raised that is repaid or kept over a period longer than one year. This is used for big purchases (capital expenditure) like buying buildings, delivery vans, or new machinery.
Memory Trick: Think of Short-term as buying petrol for the car (day-to-day running), and Long-term as buying the car itself!
2. Short-Term External Sources
A. Bank Overdraft
Definition: An agreement with a bank that allows a business to withdraw more money than it currently has in its bank account, up to an agreed limit.
• How it works: If your bank balance is £0, the bank might let you spend up to \(-\)£2,000.
• Best used for: Short-term cash flow problems, such as paying staff wages while waiting for a customer to pay an invoice.
• Advantages: Very flexible; easy to arrange; you only pay interest on the exact amount you go overdrawn.
• Disadvantages: High rates of interest; the bank can ask for the money back at very short notice.
Common Exam Mistake: Never recommend an overdraft to buy long-term assets like a building or delivery van! The high interest makes it far too expensive for long-term use.
B. Trade Credit
Definition: An agreement where suppliers deliver goods or raw materials to a business now, but allow the business to pay for them at a later date (usually 30 to 90 days later).
• How it works: A baker receives flour today, bakes and sells bread to customers for cash, and pays the flour supplier in 30 days.
• Best used for: Managing daily inventory and stock.
• Advantages: Gives the business time to sell goods before paying for them; no interest is charged if paid on time.
• Disadvantages: Suppliers may refuse discounts for early payment; if you pay late, suppliers may refuse to work with you again.
Common Exam Mistake: Trade credit is not income or sales revenue. It is money that you owe (a liability).
Key Takeaway for Short-Term Sources: Use overdrafts for emergency cash flow needs and trade credit for stocking up on inventory without immediate cash outlay.
3. Long-Term Borrowing & Asset Finance
A. Bank Loan
Definition: A fixed amount of money borrowed from a bank for a set period, which must be repaid in regular monthly instalments along with interest.
• Key Term – Interest: The extra "cost of borrowing" money, charged as a percentage of the loan.
• Key Term – Security (Collateral): An asset (like property or machinery) that the borrower promises to the bank. If the business fails to repay the loan, the bank can seize the asset to get its money back.
• Best used for: Major investments like buying property, vehicles, or expanding premises.
• Advantages: Fixed monthly payments make budgeting easy; the business keeps full control of the company.
• Disadvantages: Must be repaid with interest regardless of whether the business makes a profit; collateral is often required.
B. Hire Purchase vs. Leasing (Don't mix these up!)
Examiners frequently test whether you know the difference between Hire Purchase and Leasing.
Hire Purchase (HP):
• Definition: Buying an asset by paying a deposit and regular instalments over an agreed time.
• Ownership: The business owns the asset only after the final payment is made.
• Advantage: Spreads the cost of expensive equipment over time.
• Disadvantage: Total cost is higher than paying upfront in cash due to interest.
Leasing:
• Definition: Renting an asset (like a photocopier or company car) for a fixed period with regular rental payments.
• Ownership: The business never owns the asset. At the end of the contract, the asset goes back to the leasing company.
• Advantage: Lower upfront cost; the leasing company is often responsible for maintenance and upgrades.
• Disadvantage: The business never owns the asset, and continuous rental payments add up over time.
Summary Table of the Difference:
• Hire Purchase: You pay in instalments \(\rightarrow\) You own it at the end.
• Leasing: You pay rent \(\rightarrow\) You never own it (it gets returned).
4. Equity and Specialist External Finance
A. Share Capital
Definition: Raising long-term finance by selling a percentage of ownership (shares) in the company to investors in exchange for cash.
• Who can use it? Limited companies only (Private Limited Companies / Ltds and Public Limited Companies / PLCs). Sole traders and partnerships cannot sell shares.
• Dividends: Shareholders receive a share of the company's profits, called a dividend.
• Advantages: The money raised never has to be repaid; no interest charges.
• Disadvantages: Original owners lose some control; profits must be shared through dividends.
B. Venture Capital
Definition: Capital provided by professional investors (venture capitalists) to small or medium-sized businesses that have high growth potential, in exchange for an equity share (part ownership).
• Best used for: High-risk, high-reward start-ups or fast-growing businesses that banks might consider too risky for a standard loan.
• Advantages: Large amounts of finance available; venture capitalists often provide valuable business expertise and advice.
• Disadvantages: Venture capitalists take a significant share of ownership and demand a say in major business decisions.
C. Grants
Definition: Non-repayable sums of money provided by the government or regional development agencies (such as Invest NI) to support specific business activities.
• Best used for: Starting a business in an area with high unemployment, or funding innovative research and green technology.
• Advantages: It is "free money" – it does not need to be repaid and charges no interest.
• Disadvantages: Very difficult to obtain; comes with strict "strings attached" (e.g., you must create a certain number of jobs or locate in a specific area).
Exam Tip: Avoid writing vague terms like "the government will pay." Always use the technical term: Government Grant.
D. Crowdfunding
Definition: Raising small amounts of money from a large number of people, usually via online platforms.
• Types: Backers may receive a product/reward (reward-based) or shares in the business (equity-based).
• Best used for: Creative projects, niche consumer products, or social enterprises.
• Advantages: Generates public awareness and free marketing; useful when banks reject loan requests.
• Disadvantages: If you don't reach your target amount, you might receive nothing; copycat competitors might steal your idea once it is published online.
5. Choosing the Right Source of Finance
In your CCEA exam, you will often be given a scenario and asked to recommend the best source of finance. Use this quick decision checklist:
1. What is the time frame?
• Immediate cash flow problem \(\rightarrow\) Bank Overdraft.
• Buying raw materials or inventory \(\rightarrow\) Trade Credit.
• Buying machinery or building an extension \(\rightarrow\) Bank Loan, Hire Purchase, or Share Capital.
2. What is the business structure (Legal Form)?
• Sole Trader / Partnership (Unlimited Liability): Cannot sell shares. Best options are bank loans, hire purchase, or personal savings.
• Limited Company (Ltd or PLC): Can raise large sums through Share Capital.
3. Does the owner want to keep 100% control?
• If YES \(\rightarrow\) Choose debt finance (Bank Loan or Hire Purchase) because the bank does not take shares or voting rights.
• If NO \(\rightarrow\) Choose equity finance (Share Capital or Venture Capital) if they don't mind sharing control and profits.
6. Top Examiner Pitfalls to Avoid
• Confusing Leasing and Hire Purchase: Remember that you never own a leased asset; you only own an asset under Hire Purchase once the final instalment is paid.
• Suggesting Overdrafts for Long-Term Assets: An overdraft is strictly for short-term day-to-day cash flow problems.
• Forgetting the True Cost of Loans: Always mention interest when discussing loans. The total amount repaid will always be higher than the initial sum borrowed.
• Calling Trade Credit "Free Money": It is a short-term delay in payment, meaning it is a debt that must be settled soon.