External Finances Flashcards
Definition of external finance
External finance is investment for the business that is obtained from; banks, investors and lenders outside of the business
What is source of finance
This is where the finance has come from e.g. a bank
What is method of finance
This is the use of a finance – or what use it would be suitable for e.g. loan to buy computer equipment for the business
Sources of finance
- family and friends
- banks
- peer-to-peer funding
- business angels
- crowd funding
- other businesses
Sources:family and friends
A sole trader or partnership may also find that their family may want to contribute to the business. This may be for interest, a share of the profits or maybe even an interest free loan amongst family.
Advantages of family and friends
Loans from friends and family will probably be offered without the need for security and at lower rates and over longer terms than traditional lenders
Disadvantages of family and friends finance
Downside is that it may cause tension and problems if the finance is not repaid or the business does not flourish.
Banks
Banks may lend a loan to a business to start-up or when a business wants to grow and expand
Banks may also provide a business with an overdraft to help when they have cash flow problems
Advantages of banks
Banks will allow the business owner to continue running the business their own way, and not interfere, so the owner retains control of the business (unlike business angels)
Disadvantages of banks
Bank loans can be expensive compared to other sources of finance and interest must be paid back on time
It may be hard for a new business owner to obtain a loan as they have no historical sales data to show the bank
Peer to peer funding
Lending marketplaces such as Funding Circle have gained the trust of consumers by offering lower rates than banks to business owners who want to borrow money
Advantages to peer funding
Advantages
• Businesses can get access to funding within a week once approved
• Business owners can apply online
• Investors can expect returns of 6-7% whereas a savings account might only give them 3%
Disadvantages of peer to peer funding
Peer to peer loans are classified as private business loans, so the money for the loan comes from several investors or small businesses.
Business angels
An angel investor offers to lend their personal disposable finance
• The angel would normally take shares in the business in return for providing finance
• Angels normally seek to not only provide the business with money to grow, but also bring their experience and knowledge to help the company achieve success
Advantages of business angels
Angels are free to make investment decisions quickly
• The owner gets access to your investor’s sector knowledge and contacts
• The owner gets access to angels mentoring or management skills
Disadvantages of business angels
Not suitable for investments below £10,000 or more than £500,000
• Owner needs to give up a share of the business
Crowd funding
Crowd funding is where a large number of people fund a project over the internet making small investments each, 3 ways to fund:
Advantages of crowd funding
Good alternative to loans for small business owners
• Finance can be obtained without paying upfront fees
• The business can generate funds and also promote the business at the same time
Disadvantages of crowd funding
The business will need to show case their idea to investors and may need to put together a video and other promotional material to attract investors
Other businesses
Other businesses may wish to invest in start-ups
• A business may have surplus profit and view this as a way to get a good return on their investment
Methods of finance
- loans
- share capital
- venture capital
- overdrafts
- leasing
- trade credit
- grants
Loans
Loaning money from a bank is like “renting” the money
• Banks will lend to small business but may not lend when they first start-up as there is no track record or history of them making money.
Advantages of loans
As the loan is fixed for a certain length of time the business owner can plan ahead and knows exactly what the repayments will be and when they will leave the bank account
Disadvantages of loans
A bank will charge interest on the loan
• Not very flexible, the business may incur a penalty if they decide to settle the loan early
• A bank will ask for security or collateral on a loan this may be a house or another asset that can be seized if the loan is not paid back
Share capital
In a public limited company – plc - one that has been floated on the stock market - they can raise more finance to expand by having an ordinary share issue
Advantages of shared capital
Investors are often prepared to provide extra funding as the business grows
• More cost effective way to raise finance than a loan – no interest to pay back
Disadvantages of share capital
Potential investors may require a great deal of background information before they buy the shares
• The more shares that are sold, the more the profits have to be divided up and paid out to investors as dividends
Venture capital
Venture capitalists (VCs) will invest large sums of other people’s money in a business in return for shares in the company.
Typically, VCs will invest at least £50 000 in a small regional business although this can rise into millions of pounds.
Advantages of venture capital
Useful if the business is looking to raise a large amount of money in a short space of time e.g. £1 million
• The business gets all the skills of the venture capital business, their network and links may increase revenue streams
Disadvantages of venture capital
Venture capital firms look for a strong business plan, sound management and a proven track record, making it difficult for start-up firms
• Venture capital firms typically want 20-30% stake in the business
Overdrafts
Some months a business may need extra cash to tide it over until a better month. A loan is over many years so is not suitable.
• An overdraft may be organised by the bank which is short term lending of smaller amounts of money
Advantages of overdrafts
For a business owner this would idea as a quick fix method to tide the business over a difficult month of trading
• An overdraft can be arranged on the phone
• or online with an instant decision from the bank
Disadvantages of overdrafts
f the business goes over this amount the overdraft will be “unauthorised” and the business will be charged heavily
• Very expensive source of finance, very high charges and interest rates
• Not suitable for large amounts over a long period of time
Leasing
As a business grows it may decide that it needs some more vehicles or equipment
• They may decide to lease so that the equipment can be updated regularly and spread the cost
Advantages of leasing
This is a lower monthly costs for a business owner than a loan
• Often business leases can be arranged without any advanced fees being paid
Disadvantages of leasing
Leasing is often over a fixed term, if the business changes its mind and wants to lease from a different company, contracts may be difficult to get out of
Trade credit
When one business trades with another they will sometimes need to “buy” goods with trade credit
• The seller gives the buyer 30, 60, 90 days to pay
• The buyer then has time to sell the goods in their own shop before they have to pay for them
Advantages of trade credit
Business can sell the goods before the stock needs to be paid for, so can make a profit before the costs have to be paid
• No interest has to be paid on trade credit
Disadvantages of train credit
Not all stock is available to buy using the trade credit method, so only applies to certain industries
• If the business does not pay in time they risk being refused further credit by the supplier in the future
Grants
The UK government provides financial help to businesses in some areas of the country, in an effort to overcome problems of unemployment.
Advantages of grants
The business usually will not have to pay the grant back
• Unlike a loan there will be no interest to pay
• The business owner will get funds without any loss of control of the business
Disadvantages of grants
• A business will have to find a grant that suits their specific project, which can be difficult
• There’s a lot of competition for grants
• The business may be expected to match the funds they are awarded, eg a grant might cover part of the cost of a project
