- Ordinary Share Capital
- Venture Capital
- Loan Capital (e.g. bank loans)
- Bank Overdrafts
- Personal Sources
External Sources of Finance
Ordinary Share Capital
- Most applicable for Ltds and Plcs.
- If the business is successful, shareholders receive dividends (a share of the profits).
- Ordinary shareholders are usually given one for vote for every share they own. Ownership of 51% in a company guarantees overall control of the business.
- Votes are cast at the Annual General Meeting (ATM) where shareholders themselves decide the value of dividends.
- Creditors must be paid first before dividends are issued. Shareholders are NOT creditors.
- Some circumstances no dividend may be paid at all (for example the future of a firm may be decided on its profit being reinvested into the business to finance capital expenditure).
- Appeals to investors who take a risk and usually gain high rewards.
- Business goes into liquidation --> Holders money only returned if debt has been fully paid-off. But due to limited liability, shareholders can only lose the paid-up value of their shares and cannot be asked to pay any more money.
- Also known as permanent capital as the business will always have shareholders who own these shares. This makes it a LONG-TERM source of finance.
- Can set up the business in the first place or fund expansion plans.
Loan Capital
Loan Capital is money received by an organisation in return for the organisation's agreement to pay interest during the period of the loan and to repay the loan within an agreed time.
- Includes Debentures (Debt with no collateral and only available to limited companies), mortgages and venture capital.
- Providers of loan capital are called CREDITORS.
Bank Loan
A bank loan is a sum of money provided to a firm or an individual by a bank for a specific, agreed purpose.
- They are normally medium-term or long-term sources of finance.
Advantages:
- The interest rate and thus the repayments are fixed in advance, making it easy to budget the schedule for repayments.
- Interest rates are normally lower because of the security provided.
- The size of the loan and the period of repayment can be organised to match the exact needs of the firm.
Disadvantages:
- The size of the loan may be limited by the amount of collateral that can be provided rather than by the amount of money needed by the business.
- Less flexibility in a bank loan. The business will pay interest for the agreed period, even if the business gets into a position where it can pay off its loan early. This can be done, however, except a fee must be paid for doing this.
- More expensive than alternatives, such as personal finance. Start-ups are often charged higher rates of interest because they are unable to provide the guarantees that the bank manager might like.
Bank Overdrafts
A bank overdraft is when a bank allows an individual or organisation to overspend its current account in the bank up to an agreed (overdraft) limit and for a stated time period.
- Widely used and flexible
- Can help a business overcome the cash-flow problems of seasonal sales or which needs to buy materials in advance of a large order.
- Variable rate of interest
- Charges daily on the amount by which the account is overdrawn.
- Interest rate depends on level of risk posed by the account holder (like the bank loan)
- Security not usually required - meaning interest rates are high.
- Short-term sources of finance
Advantages
- Very flexible and can be used on a short term basis (e.g. for temporary cash flow problems)
- Interest is only paid on the amount of the overdraft being used
- Useful to seasonal businesses (who may experience cash-flow problems at certain times of the year)
- Security is not usually required.
Disadvantages:
- Cash-flow forecasts and other evidence are usually needed to show the bank manager why an overdraft is needed.
- The interest charged is usually higher than for a loan
- Banks can demand immediate repayment (although this is rare)
Venture Capital
Venture capital is finance that is provided to small or medium sized firms that SEEK GROWTH but which my be considered as RISKY by typical share buyers or other lenders.
- Business angels or merchant banks usually provide between £50,000 and £100,000.
- Could be a loan, or payment in return for share capital (or a mixture of both).
- Used to fund expansion plans
- Its a LONG-TERM source of finance
Advantages:
- Venture capital is available to firms that are unable to get finance from other sources because of the risk involved.
- Venture capitalists sometimes allow interest or dividends to be delayed if necessary because it will be hard for a business to become established
- Venture Capitalists often provide advice and guidance to help the business succeed.
Disadvantages:
- Venture Capitalists often want a significant share of the business in return.
- If high risk is involved, venture capitalists often want high payments/dividends, potentially undermining the future growth of the firm.
- It is possible that venture capitalists will exert too much influence, so the original owner may lose their independence.
Internal Sources of Finance
Personal Sources
Personal sources of finance is money that is provided by the owner(s) of the business from their own savings or personal wealth.
The 4 methods of personal sources are:
What is the finance used to fund?
1. Capital Expenditure
- Spent on fixed assets (i.e. items used over and over again)
- To fund for items that would take longer to generate enough revenue to pay for themselves: LONG-TERM source of finance is ideal.
-Items that pay for themselves much quicker (e.g. Computer equipment): MEDIUM-TERM source of finance is most relevant.
2. Revenue Expenditure
- Spending on day-to-day costs
- e.g Purchase of raw materials and payment of wages
- Has quick return
- Rely on SHORT-TERM sources of finance
Difference between Long-term, Medium-Term and Short-term?
- Long-term: 5+ years
- Medium-term: 2-5 years
- Short-term: Usually repayable within 1 year, possibly 2 years
Classification of sources of finance by time period
Which source of finance should be chosen?
1. Legal Structure of the business
- Private and Public limited companies will sell shares
- Sole Traders and Partnerships will rely on personal finance
2. Use of the finance
- If the finance is needed to ease cash-flow problems = short-term source - such as a bank overdraft
- If it is needed to buy assets (e.g. Machinery) = Medium/Long-term source - such as a bank loan
3. Amount Required
- Larger the sum - Less likely internal sources can be used. Loans or share capital needed. But a mix of both internal and external sources show the bank that the lender is also taking a risk.
4. Level of risk
- Risky = Harder to attract loans
- But venture capitalists are an option
5. Views of the owners
- Shareholders/owners may be reluctant to lose control of a firm, so they may reject shares and venture capital (based on control rather than financial grounds).
- Small firms may value independence and not want 'outsiders' to be part of the decision-making process. But some may value Venture capitalist's opinions and support.
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