External Sources of Finance
- When your business needs funds to expand, purchase equipment, or manage cash flow.
- Where do you turn if internal resources aren't enough?
- This is where external sources of finance come into play.
Share Capital: Selling Ownership in the Business
Share capital
Share capital is a form of business finance where companies raise funds by selling shares, which represent ownership in the company. Each share is a certificate of partial ownership.
- Shareholders become part-owners and may receive dividends as a return on their investment.
- This is often referred to as having "equity" in the company.
When Is Share Capital Suitable?
- Long-term investments: Ideal for funding major projects like expansion or research and development.
- Limited companies: Only available to private or public limited companies, not sole traders or partnerships.
Types of Companies Using Share Capital
- Privately Held Companies: Shares are not traded publicly, ownership is typically held by a small group.
- Publicly Held Companies: Shares are traded on stock exchanges, allowing wider access to investors.
- Share capital is not "free money."
- In reality, shareholders expect a return on their investment, often through dividends or stock appreciation.
A tech startup raises €1 million by selling 20% of its shares to investors. This capital funds product development and marketing.
Pros and Cons of Share Capital
| Advantages | Disadvantages |
|---|---|
| No repayment or interest obligations | Dilution of ownership and control |
| Large sums can be raised | Share issuance can be costly and time-consuming |
| Dividends are flexible and not mandatory | Public companies face increased scrutiny and regulation |
Loan Capital: Borrowing with Interest
Loan capital
Loan capital refers to funds borrowed from banks or financial institutions over a medium to long term, repaid over time with interest.
- Common forms include bank loans, mortgages, and debentures.
- These types of financing are essential for businesses requiring significant amounts of money for investments or operational growth.
1. Bank Loans
Bank loan
A bank loan is a sum of money provided by a bank to a business, which is repaid with interest over an agreed period.
- Bank loans are typically repaid over terms ranging from 2 to 20 years, with regular repayment schedules.
- The interest rate on a bank loan can be either fixed (unchanging) or variable (fluctuating with market conditions).
- Banks often require collateral, such as property or equipment, to secure the loan.
- This collateral can be seized if the borrower defaults on payments.
- Bank loans are usually easier to secure for businesses with a strong credit history and financial stability.
- Once agreed, the repayment terms are relatively inflexible, requiring businesses to commit to regular payments.
A software company takes out a 10-year loan to purchase servers, repaying the loan at a fixed interest rate of 6%. The loan is secured against office equipment.
2. Mortgages
Mortgage
A mortgage is a long-term loan designed specifically for purchasing property, where the property itself serves as collateral.
- Mortgages can last for up to 50 years, making them ideal for financing large assets such as land or buildings.
- The interest rate can be fixed or variable, allowing businesses to select repayment terms that suit their financial stability.
- The purchased property acts as security, which means it can be seized if the borrower fails to make payments.
- Remortgaging allows businesses to refinance their property to release additional funds, which can be particularly helpful for expanding operations.
- Mortgages are often used by businesses that want to own fixed assets instead of renting.
A retail business takes out a 25-year mortgage to buy a storefront, with a fixed interest rate of 4%. Monthly repayments are secured against the property.
3. Debenture
Debenture
A debenture is a long-term loan issued by businesses to raise capital, often with fixed interest payments over a specific term.
- Interest rates on debentures are fixed, providing businesses and lenders with predictable financial terms.
- The repayment term for a debenture usually ranges from 10 to 15 years, although some debentures are irredeemable (no repayment date).
- Debentures are secured using non-current assets like property or equipment as collateral.
- Unlike equity financing, debentures do not give lenders any ownership rights in the business, meaning no dilution of control.
- Debentures are often used by businesses that need large-scale, long-term financing without offering shares in the company.
Pros and Cons of Loan Capital
| Advantages | Disadvantages |
|---|---|
| Predictable repayment schedule | Interest payments increase costs |
| No loss of ownership or control | Collateral may be required |
| Suitable for medium- to long-term needs | Inflexible repayment terms |
| Onwer's funds are at lesser risk | Lesser profits due to interest payments |
When interest rates are low, loan capital can be an attractive option for financing large projects.
Overdrafts: Flexible Short-Term Borrowing
Overdraft
An overdraft allows businesses to withdraw more money than is available in their bank account, up to an agreed limit.
When Are Overdrafts Useful?
- Managing cash flow: Ideal for covering short-term expenses like payroll or inventory.
- Flexibility: Borrow only what you need, when you need it.
A retail store uses an overdraft to pay suppliers during a slow sales month, repaying it when revenue increases.
Pros and Cons of Overdrafts
| Advantages | Disadvantages |
|---|---|
| Highly flexible and easy to arrange | High interest rates compared to loans |
| Interest is charged only on the amount used | Banks can demand immediate repayment |
| No long-term commitment | Not suitable for large or long-term needs |
- Overdrafts are not a substitute for long-term financing.
- Relying on them for extended periods can be costly.
Trade Credit: Delayed Payment to Suppliers
Trade credit
Trade credit allows businesses to delay payment for goods or services, typically for 30 to 90 days.
Benefits of Trade Credit
- Improves liquidity: Frees up cash for other expenses.
- Interest-free: Unlike loans or overdrafts, no interest is charged.
A bakery receives flour from a supplier with a 60-day payment term, allowing it to sell products before paying for the raw materials.
