External sources of finance
AQA also says:
Spec content: Methods businesses use to raise finance — external sources (family and friends, new share issue, loan or mortgage, overdrafts, trade credit, hire purchase, government grants); Appropriateness of sources of finance.
Students should be able to: understand the main external sources of finance; analyse the advantages and disadvantages of each method for a given situation; evaluate the suitability of sources of finance for new and established businesses.
External Sources of Finance
When internal sources (retained profit, asset sales) are insufficient, businesses must raise finance externally. External finance comes from outside the business and typically involves either borrowing (which must be repaid with interest) or sharing ownership (selling shares). The right external source depends on the amount needed, the purpose, the business's size and stage, and the urgency.
| Source | What it is | Advantage | Disadvantage | Best suited to |
|---|---|---|---|---|
| Family and friends | Personal loans or investment from people known to the entrepreneur | Often flexible terms; may be interest-free or low-interest; quick to arrange | Can damage personal relationships if the business fails; amounts are typically small | Start-ups needing initial seed funding |
| New share issue | Selling new shares in the business to investors (private for ltd; public for plc) | No repayment required; investors share the risk; can raise large amounts (plc) | Ownership and control are diluted; shareholders expect returns (dividends, growth) | Growing businesses needing significant capital without taking on debt |
| Bank loan | Fixed sum borrowed from a bank, repaid with interest over an agreed term | Predictable fixed repayments; ownership retained; available to established businesses | Interest cost; must be repaid even if trading is poor; may require security (collateral) | Specific capital investments — equipment, premises, vehicles |
| Mortgage | Long-term secured loan for purchasing property, using the property as security | Enables large property purchase; long repayment period reduces monthly cost | Property at risk if repayments fail; long-term commitment; interest cost | Purchasing business premises |
| Overdraft | A facility to borrow up to an agreed limit by drawing more than the account balance | Flexible — only used when needed; interest paid only on the amount overdrawn | High interest rate compared to a loan; bank can withdraw facility at short notice; not suitable for long-term needs | Short-term cash flow gaps; seasonal fluctuations in income |
| Trade credit | Suppliers allow the business to receive goods now and pay later (e.g. 30 or 60 days) | Interest-free short-term financing; improves cash flow immediately | Must be repaid within the credit period; overuse can damage supplier relationships; losing trade credit terms is costly | Managing day-to-day working capital requirements |
| Hire purchase | Acquiring an asset by paying in instalments; ownership transfers at the end of the agreement | Spreads the cost of an asset; business can use the asset while paying for it; no large upfront sum required | Total cost higher than outright purchase (interest); asset cannot be sold until final payment; taken on as a liability | Acquiring machinery, vehicles, or equipment where capital is limited |
| Government grants | Non-repayable funding from central or local government for specific purposes (e.g. innovation, job creation, deprived areas) | Does not need to be repaid; no interest cost; no dilution of ownership | Competitive — not all applications succeed; restricted to specific uses; time-consuming to apply; often matched funding required | Start-ups and SMEs meeting specific eligibility criteria; innovation or community projects |
Choosing the Right Source
The appropriate source of finance depends on several factors:
- Amount needed — small amounts suit overdrafts or trade credit; large amounts require loans, mortgages, or share issues
- Purpose — short-term cash flow gaps suit overdrafts; long-term asset purchase suits a loan or hire purchase; acquiring property suits a mortgage
- Stage of business — start-ups often rely on family/friends, grants, and personal investment; established businesses have more options including bank loans and retained profit
- Willingness to share ownership — share issues raise capital without debt but dilute control; loans preserve ownership but create repayment obligations
Key Takeaways
- External sources: family/friends, share issue, bank loan, mortgage, overdraft, trade credit, hire purchase, government grants.
- Borrowing (loans, overdrafts, hire purchase) must be repaid with interest — preserves ownership but creates financial obligations.
- Share issues raise capital without repayment — but dilute ownership and control.
- Grants do not need repayment — but are competitive, restricted, and not guaranteed.
- Choose the source based on amount, purpose, business stage, and willingness to share ownership.