TutorChase logo
Decorative notebook illustration
IB DP Business Management Study Notes

3.1.2 External Sources

Every business, whether newly formed or established, may require external sources of finance to fund its operations, expansion or capital projects. External financing offers several options, each with its own advantages and limitations. To understand how these options fit into the broader financial planning of a company, one might also consider internal sources of finance.

Bank Loans

A bank loan is a sum of money lent by a bank to a borrower, with the expectation that it will be repaid with interest over an agreed period.

Features:

  • Term Length: Can be short-term (up to 12 months), medium-term (1-3 years) or long-term (more than 3 years).
  • Interest Rates: Can be fixed or variable. A fixed rate remains unchanged throughout the loan tenure, while a variable rate fluctuates with market rates.
  • Secured vs. Unsecured: Secured loans require collateral (assets pledged against the loan). Unsecured loans don’t require collateral but often have higher interest rates.

Advantages:

  • Flexibility: Loans can be tailored to meet specific financial needs.
  • Predictability: Regular monthly payments allow for better budgeting.
  • Build Credit History: Timely repayment can boost a firm's credit rating.

Limitations:

  • Interest Costs: Firms must pay back more than borrowed due to interest.
  • Collateral Risk: Failure to repay can result in loss of assets.
  • Strict Qualification: Not all businesses qualify, especially newer ones with unproven track records.

Issuing Shares

Issuing shares involves selling a portion of the company's ownership to raise capital. The individuals or entities that buy these shares become shareholders.

Features:

  • Types of Shares: Common shares (ordinary shares) offer voting rights but dividend payments can vary. Preferred shares offer fixed dividends but usually no voting rights.
  • Stock Exchange: Large firms may list their shares on stock exchanges, enabling them to be bought and sold by the public.

Advantages:

  • No Repayment Obligation: Unlike loans, the money raised doesn’t need to be repaid.
  • No Interest Costs: Share issuing doesn't carry the burden of interest payments.

Limitations:

  • Dilution of Ownership: Issuing shares reduces the ownership percentage of existing shareholders.
  • Dividend Expectations: Shareholders may expect regular dividend payments.
  • Public Scrutiny: If listed, a company's finances and decisions are under constant public and regulatory observation.

Venture Capital

Venture capital (VC) is finance provided by investors to small, high-risk, early-stage firms that they believe have high growth potential.

Features:

  • High Risk and High Return: VCs expect high returns due to the high risk associated with start-ups.
  • Equity Stake: In return for their investment, VCs typically take an equity stake in the company.
  • Mentorship: VCs often provide managerial or technical expertise.

Advantages:

  • Large Sums: VCs can provide large amounts of finance.
  • Expertise: They can offer valuable business advice and networking opportunities.

Limitations:

  • Loss of Control: VCs might want a say in business decisions.
  • Profit Sharing: As part owners, VCs will share in the company's profits.
  • Exit Expectations: VCs typically seek an exit strategy, like selling their stake or an Initial Public Offering (IPO), within a few years. Firms interested in such investments should consider strategies for venture exit.

Trade Credit

Trade credit is an agreement where a supplier allows a business to receive goods or services before payment is made, typically within 30, 60, or 90 days.

Features:

  • Informal Arrangement: Often based on trust and previous business relationships.
  • Interest-Free: If paid within the agreed period, no interest is charged.

Advantages:

  • Improved Cash Flow: Businesses can sell the goods before payment is due to the supplier.
  • Flexibility: Can negotiate terms based on the relationship with the supplier.

Limitations:

  • Late Payment Penalties: Interest may be charged or supply may be halted if payments are delayed.
  • Dependence: Over-reliance can make a business vulnerable if the supplier changes terms or stops supply.

In selecting the best external source of finance, a company must carefully analyse its needs, the costs associated with each option, and the potential long-term implications. Whether opting for traditional bank loans or seeking venture capital, the goal remains to ensure sustainable growth and financial stability. For deeper insight into how external financing compares to short-term financing methods, consider exploring short-term financing options. Businesses planning significant capital investments should also evaluate long-term financing options and understand tools like Net Present Value (NPV) to assess their investment decisions effectively.

FAQ

Both angel investors and venture capitalists provide capital to businesses, but they differ in their investment approach and scale. Angel investors are typically individuals who provide smaller amounts of finance, often in the early stages of a start-up. They might be motivated by both returns and a genuine interest in fostering new ideas. Venture capitalists, on the other hand, are professional groups that manage pooled funds from many investors to invest in start-ups and small businesses. They typically invest larger amounts and, due to the higher stakes, often require a significant say in company decisions. Furthermore, venture capitalists typically seek businesses with proven models poised for significant growth, whereas angels might invest based on potential or personal interest.

Deciding on the amount to raise when issuing shares is a strategic decision. Businesses need to evaluate their capital needs based on current operations, expansion plans, or any debt they wish to offset. This involves forecasting revenues, costs, and potential growth. They must also consider dilution of ownership: issuing too many shares will decrease existing shareholders' ownership percentages. The current and expected future value of the company, market conditions, and investor appetite are also pivotal. Companies often consult with financial advisers or underwriters to strike a balance between raising necessary capital and maintaining a healthy ownership structure.

Yes, there are situations where trade credit might not be advisable. If a business is uncertain about its cash flow and ability to pay within the agreed period, taking on trade credit can lead to strained supplier relationships and potential penalties or interest on late payments. Over-reliance on trade credit can also expose a business to risks if the supplier changes the terms or stops supplying, potentially disrupting operations. Moreover, some suppliers might offer discounts for immediate payments, meaning businesses that opt for trade credit could miss out on cost-saving opportunities.

Absolutely, businesses often combine multiple external sources of finance to meet their needs. For instance, a company might issue shares to raise capital while also taking a bank loan for a specific project. Combining sources allows businesses to leverage the advantages of each while potentially mitigating their individual limitations. However, it's essential to manage these sources effectively. Juggling multiple financial obligations, like loan repayments and dividend payouts, requires meticulous financial planning and forecasting. Balancing different stakeholders' interests, such as bank lenders and new shareholders, can also be challenging but is crucial for long-term success.

Interest rates are crucial in a business's decision to borrow. High-interest rates can significantly increase the cost of borrowing, making the loan less attractive as it implies higher monthly repayments and a greater total cost over the loan's tenure. Conversely, lower interest rates make borrowing more affordable, potentially encouraging businesses to take on loans for expansion or capital projects. Additionally, fluctuating interest rates, especially with variable rate loans, can affect budgeting and financial planning. A business must also consider how interest rates might change in the future, especially if considering a long-term loan, as rising rates could strain its financial resources.

Practice Questions

Explain the differences and similarities between bank loans and issuing shares as external sources of finance for a business.

Bank loans and issuing shares are both prominent external sources of finance. A key difference lies in their nature: bank loans are borrowed funds that must be repaid with interest, while issuing shares involves selling partial ownership in the company, thereby raising capital without the obligation to repay. This means loans entail interest costs and the risk of collateral forfeiture in case of non-repayment. Conversely, issuing shares dilutes company ownership and might entail regular dividend payments. A similarity between the two is their objective: both aim to provide businesses with the necessary funds for growth, operations, or capital projects.

Describe the main advantages and potential limitations of using venture capital as an external source of finance for a start-up.

Venture capital offers start-ups significant amounts of finance, often more than what might be accessible through traditional loans. Besides funding, venture capitalists often bring invaluable business expertise, mentorship, and expansive networking opportunities, all pivotal for a fledgling business. However, in exchange for their investment, venture capitalists typically acquire an equity stake, which can mean a loss of control for the original business owners. Additionally, venture capitalists seek high returns on their investments and will anticipate a lucrative exit strategy in the near future, such as an Initial Public Offering (IPO) or the sale of their stake. This can put pressure on the start-up to perform and deliver swift returns.

Dave avatar
Written by: Dave
Profile
Cambridge University - BA Hons Economics

Dave is a Cambridge Economics graduate with over 8 years of tutoring expertise in Economics & Business Studies. He crafts resources for A-Level, IB, & GCSE and excels at enhancing students' understanding & confidence in these subjects.

Hire a tutor

Please fill out the form and we'll find a tutor for you.

1/2 About yourself
Still have questions?
Let's get in touch.