External Sources of Finance |
Definition |
This is finance that comes from outside the business.
It involves the business owing money to outside individuals or institutions
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Personal Savings |
This mainly applies to sole traders and partnerships. Owners may
use some of their own money as capital to invest in the business.
For instance, a person may be made redundant by a company that needs
to reduce in size. They would receive redundancy payment that they
might use to start their own business.
This is considered an external source as it is assumed that the money
lent to the business will be paid back to the private individual in
the future, possibly with an extra amount to compensate the individual
for the help they gave. It can be a short or long term source
of finance, depending upon the amount invested and the decision of
the person using their savings.
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Commercial Banks |
We tend to consider two types of finance that banks offer to businesses,
overdrafts and loans.
If a business spends more money than it has in its bank account,
we say that it has become overdrawn. Businesses will often
have an arrangement with the bank whereby the bank will pay the
extra money provided the business will pay them back in a fairly
short period of time, with interest. This is a short term
source of finance and is useful for small amounts. It is often
used for buying supplies / inputs.
A bank loan is a long term source of finance and will often
be for much larger sums of money. A loan is useful for a business
that is starting up or looking to grow. Loans are often used to buy
fixed assets (see balance sheets) such as machinery and vehicles.
A business will pay the bank back each month in instalments and will
also pay an interest charge.
Interest - Banks are providing a service by lending money
in the form of overdrafts and loans and banks will charge for this
service (they want to make a profit too). When a business takes
a loan, it will agree to pay it back over a period of years but
it will also pay an extra charge. This charge, called interest,
is a percentage of the value of the loan.
The interest rate is set by the Bank of England and it varies.
The higher the interest rate, the greater the percentage of the loan
that the business must repay. In other words, if the Bank of England
raises interest rates, a business with a loan will find it has to
pay the bank more each month as it pays off its debt. Likewise, a
fall in interest rates will mean that the business will have lower
costs (and therefore more profit). The interest rate is an example
of an external constraint - something outside the business' control
that can seriously affect the business' performance.
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Building Societies |
A building society is a form of financial that is similar to a
bank. It also provides loans but specialises in providing mortgages.
A mortgage is a special type of loan used to buy property (factories,
shops, etc). Loans and mortgages tend to be paid back over a long
period of time, usually several years, at an interest rate.
In recent years, the differences between banks and building societies
have reduced and both are now very similar. Both can offer mortgages
and loans
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Factoring Services |
Businesses are often owed money. If you supplied car parts to local
garages, you would often deliver the products to the garages and
receive payment within a few weeks. The garages would be paying
by trade credit (see internal sources) and are in debt to
you (they are your debtors - see balance sheet).
A business may have difficulty in collecting its debts from its customers
but may need to get its hands on money very quickly. A special factoring
company may offer to handle the debt collection process for a
charge. The factoring company pays the business most of the value
of the debt first and would then collect the money from the debtor.
This is a short term source of finance.
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Share Issue |
An important source of finance for limited companies. A share issue
involves a business selling new shares that entitle the shareholders
to share in the control of the business. Each share gives the shareholder
a vote on the direction of the company. This usually means that
the shareholder can elect the board of directors of the company
each year. If the shareholder doesn't like the way the directors
are running the business, they can elect new directors. This is
a good incentive to the directors to run the business well and make
a profit which will be paid to the shareholders in the form of dividends.
The more shares a person holds, the more control they have over
a company. If one company wanted to take another company over, it
could arrange to buy over 50% of that company's shares. This would
give it a majority of control and, therefore, ownership.
Issuing new shares can raise a lot of capital that can be used for
expansion (buying more fixed assets, etc). It is a long term source
of finance. If the total number of shares rises, the votes of existing
shareholders will have slightly less significance and they will have
less control. The business will also have to pay dividends on a larger
number of shares.
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Debentures |
This is a form of long term loan that can be
taken out by a public limited company for a large sum and it will
be paid back over several years. It is usually borrowed from specialist
financial institutions.
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Venture capital |
Some individuals join together to provide finance for
new businesses that are just starting-up. They look for promising
businesses and invest in them, hoping that the businesses will grow
and that they will make a profit. This is similar to issuing shares.
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Leasing and Hire Purchase |
Leasing involves a business renting equipment that it may use for
several years or months but never own. It will have a contract with
a company who may come in to repair and service the product. The
deal may also involve the product being replaced with a new model
every so often. Businesses often lease equipment such as photocopiers.
Hire purchase involves paying for equipment in instalments. The business
will not own the item until all the payments have been made. It usually
works out more expensive to buy an item on hire purchase than paying
all at once but it does mean that the business doesn't have to spend
a large amount of money at once.
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