2.1.2 Sources of Finance: Internal and External

Sources of Finance: Internal and External

Key Definitions:

Finance: The aspect of a business that provides the numbers to help managers make better decisions, and it helps the managers count what is happening and what has happened within the business. 

Start-Up: The process of starting a new business with all of the financing. 

Internal Finance: Money that has been sourced from inside the business without any external influence.

Retained Profit: Profit that is kept within the business instead of being paid out to shareholders in dividends

Dividends: Shares of the profit of a business that is paid out to shareholders, either on an annual or bi-annual basis.

Sale of Assets: The sale of assets that are no longer needed by the business in order to raise additional finance for the business. 

Working Capital: The money used in the day-to-day running of the business.

External Finance: Money that has been invested into the business from outside of the business, such as from another business. 

Share Capital: Business finance that has no guarantee of repayment or of annual income, but it gains a share of control of the business and its potential profit. 

Collateral: An asset that is used as security for the repayment of a bank loan. It can be sold by a lender if the borrower fails to repay the loan, 

Peer-to-Peer Funding: A way for a business to raise loan finance from a group of individuals or institutions, and it is very flexible. 

Business Angels: Investors who invest in a business before it has opened its doors, taking a full equity risk (meaning that if the business fails the 'Business Angel' loses everything. 

Venture Capital: High-risk capital that is invested in a combination of loans and shares, usually in a small dynamic business.

Crowdfunding: A way of externally sourcing finance from many small investments given by individuals, often through a web-based platform such as GoFundMe.com. 

Seedcorn Capital: The early stage finance that comes from a 'Business Angel', that has the potential to 'grow' into more capital.

Loans: Money lent to a business from a bank in which the repayment time is usually set over a set period of time, with fixed interest rates charged by the bank. A loan can be short term, medium term, or long term. 

Overdraft: The agreed negative balance a business is allowed to reach on its bank account. It is a short term source of finance and the repayment to the bank comes with high interest rates. 

Leasing: The process in which a business agrees to pay a fixed monthly rental fee to hire or 'lease' an asset for a fixed period. 

Trade Credit: The business obtains goods or services from a supplier but does not immediately pay for it,instead paying when they have the ideal cash flow to do so. 

Grants: A sum of money given to a small business by the government in order to support the business start-up. 

Inflow: Money coming into a business. 

Outflow: Money that moves out of a business. 

The Need for Finance

Starting Up

New businesses that are starting up need money to invest into long-term assets, such as buildings and equipment. They also need money to buy materials, pay wages, and to pay day-to-day bills such as electricity and water bills. Inexperienced entrepreneurs often underestimate the capital needed for the day-to-day running of a business. 

Growing

Once the business is established there will be income from sales. If this is greater than the operating costs then the business will be making a profit. This should be kept in the business and used to help finance the business growth, and only later on should the owners be drawing money out from the profits. Even so there may not be enough left in to allow the business to grow as fast as it would like to. It may need to find additional finance and this will probably be from external sources, such as a bank loan. 

Other Situations

Businesses may also need finance in other circumstances, such as a cash flow problem. A major customer may refuse to pay for the goods they have bought, which could cause a huge gap in cash inflows. There could be a large order, which would require the purchase of additional raw materials from suppliers. In these situations, the business would need to find additional funding from both inside and outside the business. 

There are 2 main sources of finance: internal and external. 

Internal Sources of Finance

Capital can be generated from within the business in 3 ways:

1. Retained Profit

Profit is the best, and most common and way to finance investment into a business's future. The higher the profit, the more likely it is that the business can finance their expansion from within the business. 

2. Sale of Assets

This involves the sale of machinery, non-essential businesses, unused property. or anything that is seen as a surplus to the company. 

3. Improved Management of Working Capital

Existing capital can be made to be stretched further than it already is. The business may be able to negotiate to pay its bills later or work at getting cash in earlier from customers: the average business waits approximately 75 days to be paid, and if this period was halved then there would be a huge boost into the cash flow. 

The owner's personal savings can also be considered as an internal source of finance, as they can be invested into the business in the form of share capital or lent to the business as a director's loan. 

External Sources of Finance

If the business is unable to generate enough finance on its own through internal sources then it may need to look to external sources of finance. The are 2 main sources of external finance: loan capital (as a debt) and share capital (as an equity). Loan capital carries specific annual interest charges and must be repaid according to a an agreed repayment schedule. Share capital is usually rewarded by annual dividend payments, but the directors have the flexibility to cut those payments in  a difficult year. There is also no agreed timescale for repaying share capital, so it can be kept within the business indefinitely. The following are external sources of finance:

Friends and Family

They can provide share capital by taking an equity stake in the business and its profits, or they can also lend money. The majority of businesses start with a combination of the owner's capital and capital from family and friends. 

Banks

Banks sometimes provide loans to start-up businesses, but this is a rarity. If the bank grants a loan, the bank will insist on rock-solid collateral. If the loan is to buy, for example, a 5 year lease on a shop, the lease of the shop would be the collateral to the bank. If the business starts up without property assets then the collateral would be personal, such as the owner's house or flat. Banks are not interested in sharing the risks involved when starting a business, they just want to provide the finances. 

Peer-To-Peer Funding

As banks have become more reluctant to lend money following the recession, and this has created the opportunity for online matching platforms to match individuals who want to lend money to individual business borrowers. These websites cut out the bank middleman and therefore they allow lenders and borrowers to get a better deal - but only if the loan doesn't go sour. This seems to work well if there is an attractive-sounding business, such as a new restaurant. If the business is not interesting then lenders seems less inclined to lend money. 

Business Angels

Also known as 'venture capitalists', these people often lose their investments, but they still gain a lot from the investment too. They take huge risks when it comes to investing, as they are investing in the early stage of a business or product. In reality, business angels are very unlikely to invest in projects by the 'ordinary man', the chances of them investing in one of those projects is lower than the chance of getting a bank loan. 

Crowdfunding

This is a way of getting small investors to put their money into a new business with the help of an incentive in return for the investment. This is done over the internet through websites such as gofundme.com, and it is utilized most effectively when the sponsor also uses social media to promote the business. 

Other Businesses

Some companies allocate a portion of their capital to 'seedcorn' early-stage investments. The companies want to invest in a successful business in order to fully benefit from the initial investments. 

External Methods of Finance

Loans

The most common method of sourcing finance is from the bank, either as a bank loan or as an overdraft. A loan is usually given for a set period of time - this can be short term, medium term, or long term. The loan is then repaid either in installments or in full at the end of the loan period. The bank will charge interest on the loan, either at a fixed or variable rate, and the bank will demand collateral to provide security for the loan in case it cannot be repaid. 

An overdraft, on the other hand, allows the business to spend extra money into their bank account, with the amount of time that the business can do this being negotiable between the business and the bank. The interest charges on these are a lot higher for overdrafts, but the charges apply only to the debts and not to the business. Businesses can use the overdraft as a way of fixing short-term cash flow problems. 

Share Capital

As an alternative to debt, if the business is a limited company it can look for additional share capital from private investors or venture capitalists. The venture capitalists are particularly interested in businesses with dynamic growth prospects. They are willing to take a risk on a small business that may fail or do spectacularly well. However, once it has become a public limited company the firm may consider floating on the stock exchange and this can potentially generate more revenue for the business. 

Venture Capital

This is a way of getting outside investment for a business that is unable to raise their finances through the stock market or banks. A venture capitalist will invest smaller riskier companies, and to compensate for the risk the providers will usually require a substantial part of the ownership of the company. They are also likely to want to contribute to the running of the business, which dilutes the owner's control but brings in new experience and knowledge. Typically, venture capitalists put their money into businesses that have survived the early stages and are looking to grow. 

Overdrafts

This is something that allowed a company to spend up to an agreed negative balance on its current bank account. When the bank account is negative the company is overdrawn and the business must pay interest that is calculated on a daily basis. As the business can dip in and out of the state in which they'd need an overdraft, the interest bill at the end of the year would be a lot lower than it would be with a bank loan. Even though overdrafts are flexible and well-matched to the cash flows of small businesses, the risk involved should not be underestimated. All overdrafts are on a 24 hour recall, meaning that the bank could cancel them at any time leaving the business unable to repay the negative balance - this would force the business into administration. This is something that cannot be done with a bank loan, which is a legal agreement for a fixed amount of time. 

Leasing

For a small or fast-growing business keeping cash flow in the positive can be a huge challenge to business owners. A constant problem is the fact that they have to spend large chunks of money on needed assets and equipment. A solution to this is to lease the assets instead - meaning that the business makes an agreement to pay a fixed monthly rental fee to use the asset. In the short term it is better to lease, but in the long term it is better to buy the assets. 

Trade Credit

This is the simplest form of sourcing external finance. The business gets the goods or services from another supplier company, but they do not immediately pay for this. The average credit period is 2 months, and it is a good way to boost the day-to-day working capital for the business. However, the main disadvantage of this is that the other supplier may not be willing to trade with the business if they are late on their payments, or if they do not get paid by the business at all. It depends heavily on trust and the relationships between the businesses.

Grants

Grants are basically hand-outs of money to small businesses, often from the government or smaller local authorities. A grant may be given to encourage a business to start up in or relocation to an area that is considered valuable, often because banks have refused to loan money to the business. The government likes to boast about how much help they give to small businesses, but it rarely amounts to much. Some small firms prefer to finance their start up and growth from within the business instead of using the grants.