External Sources of Finance (Cambridge International A-Level Business)
Share capital and debentures
Share capital
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Share capital is finance raised from the sale of shares in a limited company through flotation or a rights issue
- Shareholders are the owners of shares, and they are entitled to a share of the company’s profit when dividends are declared
- Shareholders usually have a vote at a company’s annual general meeting (AGM), where they can have a say in the composition of the Board of Directors
Debentures
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A debenture is a long-term loan taken by a company, usually from external investors, with a fixed interest rate
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It does not give ownership or voting rights to the lender — unlike shares
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The company must repay the debt and interest on agreed terms, even if it makes a loss
- Debenture holders are creditors rather than owners of a business
Evaluating the use of share capital and debentures
| Benefits | Drawbacks |
|---|---|
| - Large amounts of capital can be raised, especially by public limited companies - Interest is not payable on share capital raised | - Shareholders usually have a vote at a company’s AGM, where they can have a say in the composition of the Board of Directors - Interest is payable on debentures, which must be paid back by a certain date |
New partners
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When a partnership business needs additional capital, it can raise finance by bringing in a new partner
- The new partner contributes money to the business in exchange for a share of ownership and profits
- The new partner may also bring skills, experience or contacts that benefit the business, in addition to the financial investment
Evaluating new partners as a source of finance
| Advantages | Disadvantages |
|---|---|
| - It brings in capital without the need to borrow or pay interest - The new partner may offer valuable skills or business experience alongside financial support | - Existing partners must share profits with the new partner - Decision-making may become more complicated or lead to disagreements |
Venture capital
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Funds provided by specialist investors in small- to medium-sized businesses that have significant potential for growth, e.g. in the technology sector
- These investors look to make a profit by investing in companiers and demanding a high return for their investment
Evaluating venture capital as a source of finance
| Advantages | Disadvantages |
|---|---|
| - Businesses that have been refused finance from other sources may be able to attract investment from less risk-averse venture capitalists - Venture capitalists often bring expertise, contacts, and advice that can help the business grow | - Venture capitalists usually require a stake in the business in return for their investment - They often expect to exert some control over the business |
Leasing and hire purchase
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Leasing involves making regular payments in return for the use of an asset such as a piece of machinery or a vehicle
- E.g. many businesses lease office equipment such as photocopiers and IT equipment
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Hire purchase is a method of buying an asset by paying for it in regular installments over a set period, rather than paying the full amount upfront
- Ownership of the asset passes to the business only after the final payment has been made.
Evaluating leasing as a source of finance
| Advantages | Disadvantages |
|---|---|
| - No large upfront payment is needed, which helps with cash flow - Maintenance and repair costs are usually the responsibility of the leasing company - It is easy to upgrade to newer equipment at the end of the lease | - The business does not own the asset during the lease period - Leasing is usually more expensive over time than buying the asset outright - The business may still have to commit to long-term payments even if it stops using the asset |
Evaluating hire purchase as a source of finance
| Advantages | Disadvantages |
|---|---|
| - The business can use the asset immediately while spreading the cost over time - Ownership of the asset passes to the business after the final payment - It is useful for acquiring essential equipment without needing a large lump sum | - Interest is added to the repayments, making it more expensive than buying upfront - The business is responsible for all maintenance and repair costs once the agreement begins - Missed payments could lead to repossession of the asset before it is fully paid for |
Bank overdrafts
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An overdraft is an arrangement between a business and its bank to spend more money than the business has in its account
- A **limit **is agreed upon, and interest is charged only when a business "goes overdrawn"
- It is a** short-term** source of finance that offers significant flexibility and aids cash flow
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An overdraft may be "called in" if the bank is concerned about a business's ability to repay what it owes
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Some large businesses rely heavily on overdrafts to manage working capital
Advantages and disadvantages of overdrafts
| Advantages | Disadvantages |
|---|---|
| - A short-term source of finance that offers significant flexibility and aids cash flow - Interest is only paid on the amount actually used, not on a fixed lump sum | - An overdraft may be "called in" if the bank is concerned about a business's ability to repay what it owes - Interest rates on overdrafts are often higher than on traditional bank loans |
Bank loans and mortgages
Bank loan
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A loan is a sum of money that is borrowed from a bank and repaid in instalments, with interest, over a specific period of time
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Loans can be short-term or long-term
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Banks must approve the loan application
- A detailed business plan provides evidence of the ability to repay
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Secured loans are more likely to be available to larger businesses and are typically repaid over five to 20 years
- Interest rates may vary over the term of the loan, and terms may be renegotiated if needed
- Failure to make repayments can mean a business has to convert non-current assets into cash (sell them)
Mortgages
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Mortgages are long-term secured loans
- They are typically used by a business to purchase buildings, land or large items of capital equipment
- Interest is payable, and assets are at risk if the business does not make repayments as planned
AEvaluating the use of loans
| Advantages | Disadvantages |
|---|---|
| - Interest rates are fixed for the term of the loan - Repayments are made in equal instalments, helping budgeting - Businesses can purchase expensive equipment or property without the need for large amounts of capital - Control over decision-making is retained within the business - With debentures, interest is fixed, aiding budgeting | - Interest rates depend on the business's credit rating - Non-current liabilities are increased in the balance sheet - With a mortgage, missed payments may lead to property being repossessed - Failure to repay debentures may deter investors in the future |
Debt factoring
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Businesses can sell their accounts receivable (invoices) to a third party at a discount
- The third party immediately pays the business, which means that cash is received immediately
- It helps improve cash flow quickly, but the business receives less than the full invoice amount(for example, 95%)
- Customers then pay the third party over the agreed time frame (possibly several months)
- The third part then makes profit on their transaction as they pay the business 95% of the invoice value but receive 100% of the invoice value from the customers
Evaluating the use of debt factoring
| Advantages | Disadvantages |
|---|---|
| - Debt factoring provides an immediate source of cash - The business does not have to handle debt collection themselves | - The third-party debt company will keep a percentage of the debts collected as a reward - Thus, the business does not get paid the total value of debts |
Exam Hint With debt factoring, a business gets cash in days instead of waiting months, but lose the factor’s fee (usually a % of sales)
They compare that cost carefully with the profit margin to judge if debt factoring is worth it
Trade credit
- An agreement is made with suppliers to buy raw materials, components and stock which are paid for at a later date, typically 30 to 90 days later
Evaluating the use of trade credit
| Advantages | Disadvantages |
|---|---|
| - Trade credit is usually interest-free - It improves short-term cash flow by allowing delayed payments | - Any discounts for early payment are not available - Over-reliance on trade credit may harm relationships with suppliers |
Micro-financing and crowdfunding
Micro-finance
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Micro-financing is a type of financial service that provides small loans and other basic financial support to entrepreneurs or small businesses, particularly in developing economies or low-income communities
- These businesses do not qualify for traditional loans due to lack of credit history, income or collateral
- Repayments are made in regular, manageable installments, often with lower interest rates than commercial loans
Evaluating the use of microfinancing
| Advantages | Disadvantages |
|---|---|
| - It provides access to finance for those who cannot borrow from banks - It often does not require assets or formal credit history - It may include business support or training alongside the loan | - Loan amounts are small, which may limit business growth - Interest rates, while lower than some loans, can still be high for very poor borrowers - There is limited availability in some regions or sectors |
Crowdfunding
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Crowdfunding is a method of raising finance by collecting small amounts of money from a large number of people, typically via online platforms such as Kickstarter
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Businesses seeking finance provide a persuasive business plan to convince individuals to invest in their product, competing with many other projects online
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Investors are often attracted by incentives such as samples or early access to a product
- E.g. in November 2022, well-known Twitter commentator Russ Jones published his long-awaited politics book, funded via Unbound, a crowdfunding publisher
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Evaluating the use of crowdfunding
| Advantages | Disadvantages |
|---|---|
| - It creates an organic customer base, and the platform provides a form of free marketing - A good credit rating is not required, so new businesses that lack a trading record can attract funding | - Businesses need to provide a persuasive business plan to convince individuals to invest in their product, as they will be competing with many other projects online - The potential for negative publicity if the project is not successful in attracting enough crowdfunding capital |
Government grants
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Governments and industry trusts may offer grants to businesses that meet specific criteria
- E.g. grants may be available for businesses that create jobs or improve infrastructure in a region
Evaluating the use of government grants
| Advantages | Disadvantages |
|---|---|
| - Grants do not need to be repaid - They do not **dilute ownership **of the business | - The business must use the finance for its** intended purpose** - It can be difficult and time-consuming to apply for grants |
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