Short-term external sources of finance

Short-term external finance provides businesses with quick access to funds to manage day-to-day operations or temporary cash shortages. These sources are typically repaid within a year and help maintain liquidity without long-term commitments.

Bank overdrafts

Bank overdrafts provide a flexible funding option for businesses needing occasional cash support.

Key features:

• Variable borrowing - Businesses can borrow up to an agreed limit, with the amount fluctuating daily based on needs.
• Interest charges - Often come with high interest rates applied only to the overdrawn amount.
• Risks involved - The bank may demand immediate repayment if it doubts the business's stability.
• Suitability - Particularly useful for unincorporated businesses that need occasional cash support.

Trade credit

Trade credit allows businesses to delay payments to suppliers, effectively receiving short-term financing.

How it works:

• Payment deferral - Allows businesses to receive goods or services from suppliers and pay later, typically within 30-90 days.
• Impact on suppliers - Suppliers effectively become creditors, listed as trade payables in the business's accounts.
• Potential drawbacks - Businesses may miss out on early payment discounts.

Debt factoring

Debt factoring enables businesses to convert receivables into immediate cash by selling outstanding invoices to a factoring company.

Process:

• Selling debts - Businesses sell outstanding customer invoices to a factoring company for immediate funds, receiving a percentage of the debt value upfront.
• Discount applied - The factor deducts a fee, so the business gets less than the full amount.
• Agreement transfer - Once sold, the debt relationship shifts to between the customer and the factoring firm, removing the original business from collection efforts.

Long-term external sources of finance

Long-term external finance supports major investments like equipment or expansion, with repayment periods often exceeding one year. These options help businesses grow while spreading costs over time.

Hire purchase

Hire purchase enables businesses to acquire assets through staged payments, avoiding large upfront outlays.

Key features:

• Staged payments - Enables businesses to buy assets like vehicles or machinery through instalments, avoiding a large upfront outlay.
• Ownership transfer - The business gains ownership at the end of the term after all payments are made.
• Cost considerations - Interest rates are often higher than standard bank loans, with regular payments covering both interest and part of the principal.

Leasing

Leasing allows businesses to access assets without ownership through rental agreements.

Benefits:

• Rental agreement - Businesses pay regular fees to use an asset for a set period, without necessarily buying it outright.
• Maintenance benefits - The leasing company typically handles repairs and upkeep, reducing the risk of downtime from faulty equipment.
• Financial impact - While potentially expensive over time, it preserves cash flow in the short term by not requiring a large initial payment.

Bank loans

Bank loans provide extended borrowing for major business investments.

Characteristics:

• Repayment duration - Usually for terms over one year, such as 7 years for machinery or longer for property.
• Interest options - Can have fixed or variable rates.
• Security requirements - Often needs collateral, making it harder for asset-poor businesses to secure favourable terms or any loan at all.

Debentures

Debentures are bond-based funding instruments that companies can issue to raise capital from investors.

Features:

• Issuing bonds - Companies sell these to investors, promising fixed annual interest payments for up to 20 years.
• No security needed - Unlike loans, they do not require collateral.
• Conversion potential - Some debentures can be converted into shares after a specified time.

Business mortgages

Business mortgages are property-specific loans designed for acquiring business premises.

Details:

• Property-specific loans - Designed for acquiring business premises, with the property itself serving as security.
• Interest rate types - Can be fixed for stability or variable.

Share or equity capital

Share or equity capital provides permanent funding through the sale of ownership stakes in the business.

Advantages:

• No repayment obligation - Funds raised by selling shares do not need to be repaid, except in liquidation scenarios.
• Options for private companies - Can issue additional shares to current owners.

Public selling methods:

• Alternative Investment Market - Suitable for smaller firms seeking public investment.
• Full Stock Exchange listing - Requires offering at least £50,000 worth of shares to the public.
• Prospectus or rights issue - Direct sales to the public or preferential offers to existing shareholders.

Government grants

Government grants provide targeted support for specific types of businesses or activities.

Characteristics:

• Conditional funding - Provided to small businesses or those in underdeveloped areas, often tied to criteria like job creation or specific locations.
• Non-repayable - No need to return the money if all conditions are fulfilled.

Venture capital

Venture capital provides funding for high-risk ventures with significant growth potential.

Key aspects:

• Investor involvement - Specialist firms or wealthy individuals provide funds to unlisted companies, often startups or small to medium enterprises with high growth potential but elevated risks.
• Return expectations - Investors typically demand a significant stake or a share of future profits.
• Common recipients - Frequently supports innovative or high-tech businesses that struggle with traditional financing.

Comparing loan capital and share capital

Loan capital and share capital are two major forms of long-term finance, each with distinct benefits depending on a business's structure and goals. Loan capital involves borrowing with repayment obligations, while share capital raises funds through ownership stakes.

Advantages of loan capital

• Ownership retention - No dilution of control, as lenders do not gain shares or voting rights.
• Temporary liability - Loans are eventually repaid, avoiding permanent debt on the balance sheet.
• Tax benefits - Interest payments are deductible before calculating corporation tax.
• Gearing effects - Increases the debt-to-equity ratio, which can amplify returns for shareholders if used effectively.

Advantages of share capital

• Permanent funding - No requirement to repay the capital, providing stable long-term resources.
• Flexible dividends - Payments to shareholders are not compulsory annually, easing cash flow during tough periods.
• Reduced debt levels - Lowers the overall indebtedness, improving financial ratios and perceived stability.