Share capital the money raised from selling shares of the company. The main sources of finance for a limited liability company. This can provide lots of finance.
Selling Shares: private limited companies cannot sell their shares to the general public. If they want to they can ‘go public’ by floating their shares on the stock exchange. This is known as initial public offering (IPO). Existing companies can raise further finance by selling more shares in a share issue. However by issuing shares, ownership and control of the business becomes diluted.
Loan capital
Overdrafts: allows a business to temporarily overdraw on its bank account, i.e., to take out more money than it has in its account.
Debentures: the holder of a debenture is a creditor of the company, not an owner. This means that holders are entitled to an agreed fixed rate of return, but have no voting rights and the amount borrowed must be repaid by the expiry date.
Mortgages: only limited companies can raise funds from the sale of shares and debentures. Smaller firms need long-term finances to purchase the premises, a purpose which mortgages are designed for. It is usually a long-term loan from a financial institution (like a bank) and the lender must use land or property as security on the loan. (Note: Mortgages are specialised long-term loans only for the purchase of premises, not machinery for example)
Grants: governmental financial gifts to support business activities. These tend to be offered to eligible business in one-off payments.
Subsidies: governmental grant to reduce costs of production, generally to provide benefit to society. This tends to be done for essential products and services such as agricultural goods, public transport etc. Subsidies do not cut into profit margins of the producer.
Debt factoring: when a firm sells its products, it issues an invoice stating the amount due. Debt factoring involves a specialist company (called a factor) providing finance against these unpaid invoices. So, when a debtor fails to pay its bill in time, the company turns to the factor and asks for the return of these funds, which the factor does immediately. However, when a customer pays the bill in full, the factor would usually keep 20% of the value of the invoice.
Venture capital: high risk capital invested by venture capital firms usually at the beginning of a business idea. They find small businesses with high growth potential. These firms seek businesses with convincing and coherent plans to make the risk of investment worthwhile. They then receive profit in return from their investment.
Business angels: usually wealthy individuals who invest their money in businesses with high growth potential. They provide funding and in return tend to take a proactive role in the business and receive profits until the business can buy out the stake owned by the business angel.
| Advantages | Disadvantages | |
| Hire purchase | ✔ Quick and easy to acquire equipment. |
✔ Interest rates are higher. ✔ The good can be taken away from the buyer if their payment is late. |
| Trade credit | ✔ An interest free source of finance. |
✔ The cost of goods can be higher if paid for at a later date.
✔ Delaying the payment can result in a poor relationship between the firm and its suppliers. |
| Leasing |
✔ No large sums of money need to be allocated for the purchase of the equipment. ✔ Useful when equipment is used occasionally. ✔ Maintenance is not the responsibility of the user. |
✔ In the long term, it is more expensive than the outright purchase. ✔ Interest rates are higher. ✔ Not able to secure any loans with another institution on assets that are leased. |
Frequently Asked Questions About External Sources of Finance
What are external sources of finance?
External sources of finance refer to funds raised from outside the business itself. This money is obtained from individuals, institutions, or markets separate from the company's internal operations and accumulated profits.
What is meant by external sources of finance?
It signifies obtaining the necessary capital for a business from external entities such as banks, investors (by selling ownership), other companies (via credit), or the general public (by issuing stocks or bonds). Unlike internal finance, this involves bringing new money into the business from outside.
What are some common external sources of business finance?
Common external sources include:
- Bank Loans and Overdrafts: Borrowing funds from a bank with an agreement to repay over time with interest.
- Issuing Shares (Equity Financing): Selling ownership stakes in the company to investors.
- Issuing Bonds (Debt Financing): Borrowing money from investors by issuing debt securities.
- Venture Capital and Private Equity: Investment from firms specializing in funding startups or established companies.
- Trade Credit: Receiving goods or services from suppliers on credit terms.
- Factoring/Invoice Discounting: Selling receivables to a third party for immediate cash.
- Government Grants and Subsidies: Financial aid from government bodies.
- Crowdfunding: Raising small amounts of money from a large number of people, often via online platforms.
Are family and friends an external source of finance?
Yes, generally, funds raised from family and friends are considered an external source of finance for a business. While the relationship is personal, the individuals providing the funds are outside the formal structure and operations of the business itself.
How does profitability affect access to external sources of finance?
Profitability significantly impacts access to external finance. Profitable businesses are seen as less risky by lenders (banks) and investors (equity providers). Higher profitability makes it easier and often cheaper to obtain loans (lower interest rates) and attracts equity investors who are more likely to see a return on their investment. Unprofitable businesses face greater difficulty accessing external funds, often requiring more collateral or offering higher returns to compensate for the increased risk.
Why do firms acquire external long-term sources of finance?
Firms acquire external long-term finance for significant investments and strategic growth that cannot be funded by short-term or internal sources alone. This includes:
- Funding large capital expenditures (e.g., buying buildings, machinery).
- Financing major expansion projects (e.g., opening new locations, entering new markets).
- Funding research and development for future products.
- Acquiring other companies.
Long-term external finance provides the substantial capital needed for these enduring investments.
