Internal and External Finance

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Internal or External?

When deciding which type of finance to use, a business will weight the following factors: 

The legal structure of the business - e.g. a limited company has the ability to sell shares whereas sole traders effectively rely on personal sources 

The amount required - the larger the sum, the less the firm will be able to generate through internal sources 

The company's profit levels - a highly profitable firm will not need much external help. On the other hand a less profitable firm may need external finance, but due to its circumstances may not be able to receive it

The level of risk - if a business is considered risky, it will struggle to obtain additional finance through external sources and may therefore have to rely on internal sources 

Views of the owners - shareholders may be reluctant to dilute or lose control and therefore reject shares or venture capital. Additionally many small firms value their independence and would not want outsiders influencing decision-making. 

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Overdraft

Advantages

  • They are extremely flexible and therefore good for short term finance. Can be used even for a day if the business has a temporary cash-flow problem 
  • They are quick and easy to arrange
  • Interest is only paid on the amount of the overdraft being used rather than the maximum level allowed 
  • Security is not usually required 

Disadvantages 

  • Have higher interest rates than loans 
  • Not suitable for long term source of finance 
  • The bank can ask for repayment at any time (rare) 
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Bank Loan

Security in the form of collateral is usually required for a loan 

Advantages

  • The interest rate and thus the repayment are fixed in advance, making it easy to budget the schedule for repayments 
  • Loan interest rates are lower than overdrafts because of the security provided
  • You don't have to share the profit or the control of the business unlike when shares are sold

Disadvantages 

  • Interest has to be paid - makes it more expensive compared to alternatives such as personal finance 
  • Collateral will be required for security of the loan - this may limit the amount the business can borrow
  • There is less flexiability in a bank loan so the businesses will tend to pay interest for the agreed period, even if it gets into a position where it can pay off the loan early 
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Ordinary Share Capital (Equity)

Ltd's and PLC's can sell ordinary shares. 

Advantages 

  • Interest does not have to be paid 
  • Share capital doesn't have to be repaid - the shareholders instead get a share of the profits called dividends
  • It is not necessary to pay shareholders a dividend if the business can't afford it 
  • Bringing new shareholders into a business can add to expertise - usually when provided by a venture capitalist 
  • Collateral is not needed for share capital

Disadvantages 

  • Selling shares means the original shareholders have to share decision making with the new shareholders. They could lose control if they no longer have the majority of shares. 
  • Profits are shared amongst all the shareholders and this may be greater than paying interest on a loan 
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Government Grants

It is often given to entreprenuers - start ups or PLC's expanding in areas of high unemployment. 

Advantage 

  • You don't need to repay the grant 

Disadvantage 

  • There is a great deal of competition for grants and they will only cover a proportion of the costs - you need to meet the rest yourself
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Venture Capital

Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool their money and hope the business is successful

  • The investment is usually quite high risk
  • They will often provide cash in exchange for shares in the business
  • They may take control of many decisions but can provide experience 
  • They are often called business angels if it is just one wealthy person putting in the finance 
  • Small/medium high risk companies can produce excellent returns 

Advantages

  • It is useful for high risk firms that are unable to get finance from other sources 
  • Venture capitalists can sometimes allow interest or dividends to be delayed to support the long term growth of the business and often provide advice too 

Disadvantages 

  • They often want a significant share of the business and for the high risks they will want high interest payments or dividends
  • They might exert too much influence so the owner might lose their independence 
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Retained Profit

The shareholders in a limited company expect a share of the profit as dividends but the remaining profit can be retained and used by the company.

Although shareholders may be tempted to award themselves high dividends at the annual general meeting - it is usual for the vast majority of profits to be retained in the business. 

If this source of finance is used well, the company will succeed and then the shareholders will gain dividends because there share price will rise in the future 

Research shows that over 60% of business investment comes from reinvested profit 

Advantage

  • Cheap source of finance as you don't need to pay interest

Disadvantages 

  • Low dividends may dissatisfy the shareholders.
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Sales

Sale of an unused asset

Advantage

The asset may no longer be needed by the business so it is a good source of finance 

Disadvantage 

However, if the asset is still needed by the business it may lower the long term profitability of the business 

Sale and leaseback (rent) is used if the asset is still needed but the firm wants an immediate injection of cash. The sale gives the firm immediate cash but the leaseback means that the firm pays regular sums to rent or lease the asset in the future. 

Working Capital is the day to day finance used in a business e.g. to buy stock or pay wages. If an organisation plans & controls its cash flow well, its working capital will be strong. Chasing up debtors efficiently, keeping a close eye on stock levels and controlling cash flow will all help the firm pay day to day expenses and are therefore vital ways of raising short term finance. 

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Evaluation

Finding finance may involve balancing conflicting interests. Internal sources of finance may be too limited to provide opportunities for business development. 

Obtaining external finance increases the money available but has its downsides. Borrowing too much can be risky. Raising extra share capital dilutes the control held by existing shareholders. 

Having adequate and appropriate finance at each stage in the businesses development will ensure it stays healthy. Decisions about where to obtain finance will be a matter of considering the business objectives, the stage of development of the business and the reasons for the funding requirement. 

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