2.1.2 External Finance Flashcards
What is external finance
Capital raised from outside the business
Types of external finance
Family / friends Bank Peer to peer Business angles Crowd funding Other businesses
Why businesses need finance
Bills Wagers Furniture Machinery Stock Advertising Suppliers Invest / expand Rent / buy
7 ways finance is provided
Loans Share capital Venture capital Over draft Leasing Trade credit Grant
Describe family and friends
Ads and disads
- Investment from people known to the entrepreneur
- Amount may be limited
- Repayment terms and conditions may be flexible
- May place pressure on relationships
Describe banks
- Financial institutions that are licenced to take deposits, pay interest, make loans and act as an intermediary in financial transactions, as well as provide other financial services to their customers
- Banks will have departments and employees who specialise in business banking including offering advice on topics such as methods of finance and business planning
Describe peer to peer
- The practise of an individual lending to other individuals (peers) with whom there is no relationship or contact
- Borrowers are given a credit rating
- Normally an unsecured personal loan although on some occasions collateral may be offered
- Cuts out the use of traditional intermediaries e.g. banks
- Lending is done online
- Lenders decide who they want to lend to then compete to win the lending opportunity in a reverse auction i.e. the lender willing to offer the lowest interest rate wins
Describe business angels
- Wealthy individuals make personal investments into start-up businesses in return for a share of the business i.e. percentage equity
- Can be seen as high risk as the business is not established but angels will assess the potential for reward
- The entrepreneur will need to demonstrate a good understanding of their business model and present a detailed business plan in order to secure the investment
- Business angels may also offer support and expertise
- Some business angels form groups to share research and make joint investments
Describe crowd funding
- Crowdfunding involves raising finance from a large number of people each investing different, often small, amounts of money
- The business uses the internet to explain how much money is required, how it will be used and the exit strategy stating predicted return on the investment
- The investor is only tied into their promised contribution if the total amount is raised
Describe other businesses
- Businesses with healthy cash balances may look to invest in other businesses
- This may be with a view to higher potential returns than the business is receiving with cash sat in the bank
- This is particularly true at present with low interest rates
- Alternatively this may be to support another business
- Set up a subsidiary business
- Support a supplier
- Support a customer
Describe loans
●A set amount of money provided for a specific purpose, to be repaid with interest, over a set period of time
●May be secured against an asset and if there is a default on repayments the asset can be taken
●Financial institutions can vary interest rates depending upon the amount of risk placed on the loan
●An external source of finance generally considered to be more suitable for longer-term projects
Loan advantages
●Quick and easy to secure
●Fixed interest rates allow firms to budget
●Improved cash flow
●The borrower retains ownership of the company
Loans disadvantages
●Interest must be paid regardless of financial performance
●A firm that is highly geared i.e. has a high proportion of capital raised through debt, may be seen as high risk
●A firm normally provides security known as collateral
●Often more expensive than other forms of finance
●Can be charged a penalty for early payment
Describe share capital
●Finance raised from the sale of shares
●This is a form of equity capital i.e. the shareholder becomes a part owner of the business
●Shareholders will be rewarded for their investment by the payment of dividends but may also benefit from an increase in share price increasing the value of their shares
●Only an option for incorporated businesses i.e. Ltds and Plcs
●Issuing shares is a complex and costly process so only really an option for raising large amounts of finance to fund long term projects
Share capital advantages
●Only need to pay dividends if a profit is being made and the amount of dividend is not fixed
●Possible to raise large amounts of finance
●No interest repayments
Share capital disadvantages
●Loss of ownership as shareholders are part owners
●Potential risk of loss of control for a Plc with a threat of hostile takeovers
●Complex and costly process of issuing shares, especially for a Plc
Describe venture capital
●Investment from an established business into another business in return for a percentage equity in the business
●Also known as private equity finance
●Venture capitalists will normally look for a high rate of return in a specific time period
●The business or entrepreneur may also benefit from expertise and mentoring from the venture capitalist
●Often associated with high risk start-ups
Venture capital advantages
●Potential for large sums of money for investment
●Expertise to help the business
●Makes it easier to attract other sources of finance
●Provides the required capital for expansion
Venture capital disadvantage
●A long and complex process
●Expert financial projections are likely to be required
●Initially expensive for the firm e.g. legal and accounting fees
●Partial loss of ownership
●Risk of conflict or perceived interference
Describe over draft
●An overdraft is the facility to overspend on a current account up to an agreed sum
●The business in effect can withdraw money from the account that is not there meaning they go overdrawn or in the red
Good short term source of finance
Over draft advantages
●Only borrowed when required allowing flexibility
●Only pay for the money borrowed
●Quick and easy to arrange
●No charges for paying off the overdraft
Over draft disadvantages
●The bank can call it in at any time
●Only available from a current bank account
●Interest payments tend to be variable making it more difficult to budget
●Banks may secure the overdraft against the business’ assets
Describe leasing
- Leasing allows a business to benefit from the use of an asset without owning it or buying it outright
- The business pays a set amount in instalments to lease the asset for a pre determined period of time
Describe trade credit
- Leasing allows a business to benefit from the use of an asset without owning it or buying it outright
- The business pays a set amount in instalments to lease the asset for a pre determined period of time
Advantages of trade credit
●No interest payments
●No loss of business ownership
Disadvantages of trade credit
●No additional finance is being raised
●Might have to pay more for the goods than if payment is made immediately
Describe grants
- Grants are fixed amounts of capital provided to business by the government or other organisations to fund specific projects
- Often conditions are attached to the grants for example:
- Locate in an area of high deprivation
- Provide employment
- Reduce negative environmental impacts
- Support a good cause
Grants advantages
●Injection of capital
●Does not need to be repaid
●No interest payments
●No loss of business ownership
Grant disadvantages
●Sometimes you have criteria you have to meet
●Not everyone qualifies for a grant
How is the method of finance different to the source of finance
Source - where you get it from
Method - how you get it
