External sources of finance refer to funds obtained from individuals or institutions outside the business. These sources are essential for firms that require additional capital to maintain operations, invest in assets, or pursue growth opportunities when internal resources are insufficient. A clear understanding of these external options allows businesses to choose the most appropriate method depending on their financial situation, the purpose of the funding, and the time frame involved.
Overdrafts
Definition
An overdraft is a form of short-term borrowing where a business is allowed to withdraw more money from its current bank account than it actually has, up to an agreed limit. The business pays interest only on the amount it has overdrawn, not the entire facility.
Key Features
Designed for short-term needs, usually to cover temporary cash flow gaps.
Often used to manage day-to-day working capital requirements.
Flexible access to funds—businesses can dip in and out as needed.
Interest is charged daily on the overdrawn balance.
Often includes arrangement fees and may require regular renewal.
Advantages
Immediate access to funds, helping businesses cope with unexpected expenses.
Provides flexibility, as there is no fixed repayment schedule.
Only pay interest on the amount actually used.
Can help a business maintain its operations without interruptions.
Disadvantages
Interest rates are usually very high, making it an expensive source.
The facility can be withdrawn by the bank at any time, adding risk.
Businesses may become reliant on overdrafts for cash flow support.
Not ideal for long-term investment or funding major projects.
Example
A florist may face cash shortages during off-peak months. They might use a £3,000 overdraft facility to pay suppliers while waiting for customer payments in the run-up to a major holiday like Valentine’s Day.
Loans
Definition
A loan is a financial agreement where a lender provides a fixed sum of money to a borrower, who agrees to repay it over time with interest. Loans are typically medium- to long-term in nature and are often used for capital investments or business expansion.
Key Features
Fixed loan term, e.g. 3 to 10 years.
Regular repayments that include capital and interest.
Interest may be fixed (predictable) or variable (based on market rates).
May be secured (against assets) or unsecured.
Banks may require financial projections and a business plan.
Advantages
Enables funding of larger investments, such as machinery or premises.
Repayment schedules allow for long-term budgeting.
Interest costs may be lower than other forms of borrowing like overdrafts.
Retains full ownership and control of the business.
Disadvantages
Requires regular repayments regardless of business performance.
May include early repayment fees or restrictions on additional borrowing.
Often requires collateral, which can be seized if the business defaults.
Application process can be lengthy and stringent.
Example
A café owner may take out a £50,000 loan with a 6% fixed interest rate, repaid over five years, to renovate and expand the premises.
Sample Loan Repayment
If a business borrows £20,000 at 5% annual interest over 4 years with equal annual repayments:
Total interest = 5% of £20,000 = £1,000 per year.
Total repayment over 4 years = £20,000 + £4,000 = £24,000
Annual repayment = £6,000
Share Capital
Definition
Share capital is money raised by a company in exchange for issuing shares to new or existing shareholders. This is a long-term source of finance and is used primarily by limited companies.
Key Features
Shareholders receive a share of profits through dividends.
Shares can be ordinary (voting rights and dividends) or preference (priority dividends but no voting rights).
Does not require repayment, but ownership is diluted.
Advantages
No obligation to repay the capital or pay interest.
Can improve the gearing ratio and financial stability.
Investors may bring expertise, networks, and credibility.
Suitable for raising substantial amounts for growth.
Disadvantages
Reduces existing owners' control and decision-making power.
Dividend expectations may reduce retained profits.
Issuing shares is subject to legal and administrative procedures.
Valuation of business can be complex and contentious.
Example
A sustainable clothing brand might raise £500,000 by offering 10% of the company to a group of eco-conscious investors to fund entry into the European market.
Venture Capital
Definition
Venture capital (VC) refers to high-risk investment in start-ups or young businesses with strong growth potential. Venture capitalists provide funding in exchange for equity and strategic involvement in the business.
Key Features
Venture capitalists often bring strategic direction, mentoring, and market knowledge.
Usually invested in stages (seed, growth, expansion).
Exit strategies (e.g. IPO or acquisition) are planned in advance.
Advantages
Provides significant funding and guidance to new businesses.
No regular repayments—capital is repaid through share sales during exit.
Adds credibility and market confidence.
Useful when businesses are too risky for traditional lenders.
Disadvantages
Loss of ownership and independence.
Investors may seek a controlling stake and board influence.
Demanding growth targets and pressure for high returns.
Time-consuming due diligence and negotiations.
Example
A health-tech startup developing AI diagnostic tools might receive £1 million from a venture capital firm in exchange for 25% equity, with the investor also sitting on the company’s board.
Debt Factoring
Definition
Debt factoring involves a business selling its trade receivables (invoices) to a third party (a factor) at a discount in exchange for immediate cash.
Key Features
Typically, 80–90% of the invoice value is advanced by the factor.
The factor collects payments from customers directly.
Helps firms convert credit sales into instant cash.
Advantages
Immediate cash injection improves working capital.
Reduces the risk of bad debts and administrative costs.
Allows businesses to focus on core operations rather than debt collection.
Disadvantages
A portion of revenue is lost due to discounting.
Customers may perceive the use of factors as a sign of financial weakness.
Loss of direct customer relationship, as collection is handled externally.
Example
A manufacturer with £200,000 in outstanding customer invoices may factor them for 85%, receiving £170,000 immediately to pay for raw materials and wages.
Sample Factoring Calculation
Invoice value: £10,000
Factor advances 85% = £8,500
Factor's fee: £500
Remaining balance = £1,000 (held until full customer payment, then released)
Crowd Funding
Definition
Crowd funding is a method of raising small amounts of money from a large number of individuals, usually via online platforms. It is used by businesses, start-ups, and creative projects to secure early-stage finance.
Key Features
Can be reward-based, equity-based, or donation-based.
Projects are usually presented via platforms like Kickstarter, Crowdcube, or Seedrs.
Campaigns often include video pitches, targets, and deadlines.
Advantages
Low entry barriers—suitable for small and start-up businesses.
Builds an early community of supporters and customers.
May attract media attention and publicity.
No traditional loan obligations in reward-based models.
Disadvantages
Not guaranteed—many campaigns fail to reach targets.
Takes significant effort in marketing and engagement.
Funds raised are often modest relative to other sources.
Failure is highly visible, which can damage reputation.
Example
A tech entrepreneur may raise £100,000 from 1,000 contributors through equity crowd funding to launch an eco-friendly smart home device, offering investors a 5% share in the business.
Appropriate Usage of External Finance Options
Businesses must evaluate each source based on the purpose of the finance, its duration, the risk involved, and the impact on ownership and control.
Overdrafts are best for bridging short-term cash flow gaps.
Loans are ideal for buying equipment or vehicles.
Share capital suits firms looking for long-term expansion without repayment pressure.
Venture capital is appropriate for innovative start-ups with high potential but higher risk.
Debt factoring provides immediate cash for invoice-based businesses.
Crowd funding is best for creative, community-driven ventures with viral appeal.
Understanding these options in detail helps businesses avoid financial strain, maintain operational efficiency, and achieve their growth objectives more strategically.
FAQ
Debt factoring offers immediate access to cash tied up in receivables without increasing the business’s liabilities. Unlike loans, which require credit checks and structured repayments with interest, factoring relies on the value of existing invoices. It’s useful for businesses experiencing cash flow problems but with strong sales. Factoring also offloads debt collection responsibilities, saving time and administrative effort. However, businesses forgo a percentage of their revenue, making it more cost-effective only if the improved cash flow outweighs the discount loss.
Issuing share capital means bringing in external investors, which results in dilution of ownership and potentially losing control over key decisions. Shareholders may demand regular dividends, reducing retained profits. If expectations aren’t met, investor dissatisfaction can lead to strategic conflict. There's also a reputational risk if share issues fail to attract sufficient interest. Finally, public limited companies must meet disclosure requirements, increasing administrative costs and transparency obligations, which may not suit businesses preferring confidentiality.
Venture capitalists assess several key factors: the strength and experience of the management team, uniqueness and scalability of the product or service, potential market size, projected financial returns, and exit opportunities. They also look at existing traction, such as sales figures or user growth, and evaluate the competitive landscape. VC firms typically invest in high-risk, high-return opportunities and expect a significant equity stake in return, often with influence over strategic decisions through board representation.
Crowd funding thrives on public interest and community engagement, making it ideal for creative ventures with strong storytelling potential or social value. It allows businesses to validate demand before full-scale launch and attract early adopters willing to support innovative ideas. Since contributions often come in exchange for early product access or rewards rather than ownership, it avoids control dilution. Niche businesses benefit by directly connecting with their target audience, though campaign success depends heavily on marketing and presentation.
Overdrafts are unsuitable for long-term finance or capital investments due to their high interest rates and the risk of sudden withdrawal by the bank. Businesses with ongoing cash flow issues may become overly reliant, risking financial instability if the facility is reduced. Overdrafts can also worsen financial health indicators, like gearing, and banks may impose fees or demand collateral. Therefore, businesses needing consistent and predictable finance should consider structured loans or equity funding instead.
Practice Questions
Analyse the benefits and drawbacks to a small business of using crowd funding as a source of finance. (9 marks)
Crowd funding allows small businesses to raise capital without relying on banks, making it useful for those with limited credit history. It helps build customer interest before launch and avoids debt repayment, improving cash flow. However, campaigns require time and marketing skill, with no guarantee of success. Public failure can damage reputation and investor relations. There’s also a risk of idea theft if exposed too early. While effective for creative or community-focused businesses, it may not be suitable for high funding needs or complex ventures. The usefulness depends on the business model, target market, and product appeal.
Assess whether a fast-growing technology start-up should use venture capital as a source of finance. (12 marks)
Venture capital provides large funds and strategic expertise, helping fast-growing tech start-ups scale quickly. The investor’s experience and networks can support entry into new markets. No repayment obligation helps preserve cash flow. However, accepting venture capital dilutes ownership and may reduce founder control. Investors often seek high returns and influence, increasing pressure to deliver results quickly. Start-ups may be forced into exit strategies like IPOs. The decision depends on the start-up’s growth ambition, financial need, and willingness to share control. If rapid expansion is key, venture capital is appropriate; if retaining independence matters more, alternative finance may be preferable.
