External Sources of Finance

Sources of finance are the various ways that a business gets its money in order to run the business, such as from personal funds, share capital or bank loans. The sources of finance for a business can be classified as either internal sources or external sources.

External sources of finance are those that come from outside the organization, usually with the help of a third party provider. Due to the higher costs, external finance is only used when a business is unable to get enough funds from internal sources. There are eight sources of external finance in this course:

Share capital
Loan capital

Overdrafts
Trade credit

Crowdfunding
Leasing

Microfinance providers
Business angels

Share Capital

Share capital (also known as equity capital) is finance raised through the issuing of shares via a stock exchange (or stock market). It is a long-term source of finance for Public Limited Companies, obtained by selling shares in the company. When a Public Limited Company sells its shares for the very first time on a public stock exchange, this is called an initial public offering (IPO).

Understanding the 'Stock Exchange'

A stock exchange is a well-organized and highly regulated marketplace where individuals and businesses can buy and sell shares in publicly held companies.

The main functions of a stock exchange are to:

enable existing companies to raise share capital (through a share issue)
oversees the initial public offering (IPO) of new publicly held companies
to provide a market for trading of second-hand shares and government bonds.

Advantages of Share Capital

It is permanent capital as it does not need to be repaid. Share capital is generated from the initial sale of shares to investors. It does not include shares traded in the secondary market after they have already been issued -shareholders sell their shareholdings to other buyers via the stock exchange.
Share capital can provide significant funding for limited liability companies, especially for large projects or business growth/expansion, by attracting a broad pool of investors.
Unlike loan capital, share capital does not involve debt nor does in incur interest repayments. This reduces the expenses of the company and helps to improve its cash flow position.
It improves the company's gearing (its debt to equity ratio). A relatively degree of debt makes the company more attractive to commercial lenders and can enhance the firm’s ability to obtain future debt financing on more favourable terms.
Any public limited company can raise further finance by selling additional shares (a process known as a share issue).

Disadvantages of Share Capital

Shareholders need to (at some point) be paid dividends if the company earns a profit. This can be a financial burden on the company and limit the available funds that can be retained for investment purposes.
Although share capital can raise a lot of money for a company, the ownership and control of existing shareholders may be diluted.
The costs of issuing shares can be expensive, especially through an initial public offering (IPO), which includes professional fees, legal expenses, and marketing costs.
Only publicly limited companies can trade their shares using the stock market. Publicly limited companies must comply with stringent regulatory requirements, including financial disclosures and annual reporting standards, which can be costly and time-consuming for these businesses.
Note that shares in privately limited companies cannot be traded on a stock exchange, as their shares are not sold to the public. For these organizations, share capital is typically raised by selling shares to pre-approved family members, relatives, and close friends

Loan capital

Loan capital, sometimes known as debt capital, refers to borrowed funds from financial lenders, such as commercial banks. It is typically a long-term source of external finance. Hence, loan capital appears as part of a firm's non-current liabilities in the balance sheet. Loan capital is typically used to purchase non-current assets, such as machinery and property.

Advantages of Loan Capital

It enables the borrower to repay in regular instalments, making loan capital more accessible and affordable for many businesses as it is not burdened by having to pay a large lump sum of money.
Large businesses are often able to negotiate a lower rate of interest on their loans (financial economies of scale).
Loan capital is suitable if the owners need to raise finance but do not want to dilute their ownership or potentially lose control through issuing shares.

Disadvantages of Share Capital

Interest is charged on the amount of borrowed funds. The interest rate can be a fixed or variable rate.
In many cases, businesses have to offer collateral (security) before loans can be approved. Failure to repay the loan can lead to the lender being able to legally seize the firm’s assets to pay for the outstanding amount borrowed.
Firms that borrow loan capital on variable interest rates may suffer from liquidity problems if the rate of interest increases, because their debt repayment burden will increase.

Overdraft

An overdraft is a banking service that enables customers (personal and business customers) to withdraw more money from their account than exists in the account. This can help businesses to meet their short-term liquidity needs, especially in emergency situations. The overdraft has to be pre-approved to avoid expensive bank charges, as does the maximum amount that can be overdrawn.

Advantages of Overdrafts

Overdrafts are quite easy to obtain, so are an important source of external finance for small businesses in particular.
Overdrafts provide businesses with emergency funds to finance their operations, such as making payment to suppliers or paying wages to staff, during times when liquidity is a problem.
It provides great flexibility for businesses as overdrafts are only used as and when needed.

Disadvantages of Overdrafts

Interest is charged on the amount overdrawn, usually at rates higher than those charged for ordinary bank loans.
Banks usually only lend a small amount of money, in order to keep a business operation; it is not a suitable source of finance for purchasing non-current assets, for example.
Banks can ask for overdrafts to be repaid at very short notice.
It is essentially a high cost, short-term loan for businesses.

Trade Credit

Whilst individual customers may use credit cards to pay for their purchases, business organizations use trade credit. Trade credit enables a customer to purchase and obtain goods and services but to pay for these at a later date. The supplier provides the trade credit to the customer (another business organization), which helps the purchaser’s cash flow as they can obtain supplies without having to pay for these immediately.

The typical trade credit period is between 30 to 60 days, depending on the industry in question (some even allow up to 90 days). This means that it is possible to sell the goods bought before actually having to pay for them! Hence, trade credit can be an important external source of finance for businesses struggling with cash flow. Buying goods and services on trade credit does not incur any interest charges if the amount owed is paid in full within the trade credit period. This makes trade credit relatively attractive compared to overdrafts.

Advantages of Trade Credit

Improved Cash Flow: Allows businesses to obtain goods or services without immediate payment, helping to manage cash flow more effectively. This can be particularly beneficial for businesses with seasonal sales patterns.
Interest-Free Period: No interest charges if the amount is paid in full within the trade credit period (typically 30-60 days, sometimes up to 90 days). This makes it an attractive option compared to interest-bearing finance sources like overdrafts.
Potential for Profit Before Payment: Businesses can potentially sell goods before having to pay for them, improving profitability. This is especially valuable for businesses with quick inventory turnover.
No Collateral Required: Unlike many loans, trade credit typically doesn't require collateral, making it accessible to more businesses, particularly small and medium-sized enterprises.

Disadvantages of Trade Credit

Limited Credit Period: The credit period is typically short (30-60 days), which may not be enough for some businesses, especially those with longer cash conversion cycles.
Potential for Late Payment Penalties: Failure to pay within the credit period can result in penalties, damage to the business relationship, and negative impacts on the business's credit rating.
Cash Flow Challenges: If not managed properly, multiple trade credit agreements can lead to significant outflows when payments are due, potentially causing cash flow problems.
May Encourage Overspending: Easy access to credit might lead to overbuying or poor inventory management, particularly if a business lacks strong financial controls.

Crowd Funding

Crowdfunding is an external source of finance that involves raising small amounts of money from a large number of people to fund a particular business project or venture. This is typically done via online platforms. These supporters are collectively known as the ‘crowd’ and the business entity is referred to as the 'fundraiser'. Crowdfunding is often used by musicians, filmmakers, and artists who have successfully raised finance to fund their commercial productions.

Watch the clip on the right for an overview of crowd funding

Typically, equity crowdfunding involves the sale of a stake in a business to a number of investors in the crowd. This works in a similar way to the sale of shares or finance raised by business angels, although the amount of money from each person is much lower. Many crowdfunding platforms operate an "all-or-nothing" funding model. This means that if the fundraiser does not reach the target needed to fund the business project or venture, every member of the crowd gets their money back. There is also donation-based crowdfunding, in which case individuals donate small amounts of money to help fund a specific charitable project while receiving no financial stake or return for doing so.

Crowdfunding has become popular recently with small and medium-sized enterprises. This is mainly because commercial banks have been less willing to lend money due to the aftermath of the global financial crisis of 2007 - 2009 and ongoing COVID-19 pandemic. At the same time, people with savings have received very low rates of interest on their cash deposits at banks since the global financial crisis. Coupled with higher rates of inflation in the post-COVID era, this means savers are actually losing value on their savings over time as the rate of the rise in average price levels exceeds the interest rate for savings. Consequently, crowdfunding becomes a relatively more attractive investment option for people with savings.

Advantages of Crowd Funding

As each individual lends a relatively small amount of money to the fundraiser, this limits the risks and impacts should the business project fail to succeed.
It avoids the need for business owners or entrepreneurs to deal with commercial banks, which is often a time-consuming and bureaucratic process.
Many people can invest in the business, so this can help to raise lots of much-needed finance for small to medium-sized enterprises.
Unlike business angels, individuals of the crowd do not take any controlling interest in the organization.
Crowdfunding is usually less costly than being listed on a public stock exchange.

Disadvantages of Crowd Funding

There are legal challenges and considerations, such as transparent disclosure of legal documents, holding annual general meetings with investors, and publication of annual reports. This adds to the costs of the business.
There needs to be due diligence (investigation and exercise of care prior to entering into a contractual agreement with another entity). Investors have the option to ask for additional information from the fundraiser, so this can delay decision making and incur additional costs for the business.
Theft of intellectual property is commonplace. Entrepreneurs are vulnerable to others stealing their business ideas, largely due to the absence of intellectual property protection (see Unit 5.8 Research and development) in terms of the lack of knowledge and finance to defend these rights.
There are a lot of cases of crowdfunding scams. The loose regulatory requirements for crowdfunding in many parts of the world exposes investors to fraud.

Leasing

Leasing involves the business or customer (known as the lessee) drawing up a contract with the leasing company (known as the lessor) to use particular non-current assets for an agreed fee. Example of leased non-current assets included: machinery, tools, equipment, photocopiers, computers, vehicles or premises. It is a common option for businesses to access non-current assets without the high costs of capital expenditure.

Leasing enables a business to use these assets without having to purchase them outright (which may be unnecessary or too expensive for some businesses). In many cases, the lessor allows a long-term lessee (usually lasting three or more years) the option to buy the asset at the end of the lease agreement.

Advantages of Leasing

The lessee does not have to purchase the expensive equipment, machinery, vehicles, or other type of capital. Instead, its money can be used for revenue expenditure purposes.
The lessor takes responsibility for the maintenance of the capital equipment and other leased property. This helps to cut the operating costs of the lessee.
Leasing is particularly advantageous if the business only needs to use the fixed capital for a short period of time, or if it does not want to deal with the hassles and costs of repairs and maintenance.

Disadvantages of Leasing

With leasing, the lessee never owns the asset. Ownership remains with the lessor (the leasing company) before, during and after the leasing contract.
Over a long period of time, leasing can be more expensive than buying the asset outright due to the accumulated costs of leasing the asset over time.

An extension of this finance strategy combines the sale of assets (an internal source of finance) with leasing. This is known as sale and leaseback. This financial strategy involves a business divesting its tangible non-current assets (by selling the assets) and subsequently entering into a lease agreement to regain access to and use of same assets. Sale and leaseback gives the business immediate liquidity without losing the asset (although ownership of the asset changes).

A common example of sale and leaseback is the airline industry. Airlines often own a fleet of aircraft, which are highly expensive non-current assets. During times of financial need, such as a global financial crisis or the COVID-19 era, an airline company might engage in a sale and leaseback arrangement. This would involve the airline company selling its aircraft to a leasing company (such as Avolon, a leading global aviation finance company,) and then lease them back straight away. This provides an immediate injection of cash for the airline company, which can be used for various purposes such as debt repayments or upgrading its management information systems.

Another example is the retail sector where retail chains may own their own stores (properties). Again, during times when the retail chains face a liquidity crisis so need to raise finance, they might opt for a sale and leaseback strategy. The retailers would sell their properties to an investor and simultaneously lease them back to maintain their business operations. As with all leasing arrangements, there is a need to negotiate favourable lease terms and conditions, as well as the long-term considerations and costs associated with leasing.

Microfinance

Microfinance providers are for-profit social enterprises that offer a financial service to those without a job or on very low incomes. These members of society would not ordinarily be able to secure bank loans. The concept of microfinance was developed by Nobel Prize winner Muhammad Yunus (http://www.muhammadyunus.org/ ) in 2006, in association with the Grameen Bank.

The aim of providing microfinance is to help entrepreneurs, especially women, struggling to finance their business start-ups to gain access to loans of a small amount. Around 97% of borrowers at the Grameen Bank are women. Microfinance can give borrowers the opportunity to become self-sufficient and empower them to run their businesses. As with the majority of loans, interest is charged on the amount borrowed, although these are typically lower than what commercial banks would charge.

Advantages of Microfinance

The advantages of establishing a business as a microfinance provider as a form of for-profit social enterprise include:

Microfinance can help many people to get out of poverty by making them become financially independent.
Around half of the world’s people live on less than $2 a day, (with the vast majority of these living in low-income countries or highly indebted poor countries) so microfinance can help to provide poverty relief.
They help to empower entrepreneurs of small businesses, especially women and the underprivileged working and living in low-income countries.
Microfinance can create benefits for the wider community, such as improved healthcare, education and employment opportunities.
Microfinance providers act in a socially responsible way by helping the poorest and most vulnerable adults in society.
Microfinance can help to build and foster a culture of entrepreneurialship and economic independence.

Disadvantages of Microfinance

However, there are potential drawbacks of establishing a business as a microfinance provider. These limitations include the following points:

Some people regard the practice of microfinance providers as being unethical as they earn profits from low-income individuals and households.
Microfinance only provides finance on a small scale, so is unlikely to be sufficient to make a real difference to society as a whole.
Microfinance loans incur interest charges, so can be rather expensive for small business owners who find it difficult to earn enough revenue to keep up with their loan repayments.
Microfinance increases the debts of entrepreneurs who may subsequently struggle in their business venture.
Due to relatively low profitability, microfinance providers may struggle to attract and/or retain employees and managers, given that their remuneration packages are unlikely to be matched by larger for-profit financial companies such as commercial banks and insurance companies.

Business Angels

Business angels (or angel investors) are wealthy and successful private individuals who risk their own money in a business venture that has high growth potential. The finance from business angels is their own (personal investors). This external source of finance represents a high degree of risk.

Angel investors often come from private equity firms.These are specialist finance companies that provide funding in exchange for equity ownership or a share of future profits in the businesses seeking capital. This form of external finance often involves a hands-on approach from the private equity firm in managing and growing the partner business.

Advantages of Business Angels

Business angels provide an essential source of finance for start-ups and small businesses that are unable to secure finance from conventional providers of finance, such as commercial banks and other financial institutions.
The business can benefit from the expertise and experiences of the business angels, who are likely to provide their input in order to secure a significant return on their investment (ROI).
It is particularly useful for small businesses and inexperienced entrepreneurs who are unable to raise sufficient finance on their own, such as those which are unable to secure loan capital or those that are not permitted to sell shares on a public stock exchange.

Disadvantages of Business Angels

For the business angels, such business ventures are extremely high risk, especially as they risk losing their personal money. Hence, the amount of finance available is often not easily available for start-ups and small businesses.
This also means that there are no guarantees than angel investors will earn a satisfactory ROI, despite the high potential returns.
Such finance is difficult to come by, not only due to the risks involved but also due to the large number of entrepreneurs competing for such funds. You only have to watch an episode of Dragon’s Den or Shark Tank to realise this.
The use of business angels will dilute the firm’s control and ownership as the angel investors will want a share and say in the organization.

Knowledge Check

Check your understanding of External Sources of Finance by completing the knolwedge check on the right.

Knowledge Check - External Sources of Finance