Internal and External Sources of Finance: Building Blocks of Business Financing

Identify the key external and internal sources of finance, and learn to appraise the potential appropriateness of each of these sources of finance.

The investment process involves obtaining funds, evaluating available investment opportunities and making a selection, structuring the terms of the investment, implementing the deal and monitor progress, achieving returns and exiting from the investment.

External Sources of Finance

External sources of finance for a startup can include bank loans, grants from government, venture capital funding, angel investors, crowdfunding, equity financing.

External Sources of Finance

• Long-Term: Ordinary Shares, Preference shares, Borrowings, Finance leases, Hire-purchase agreements, Secutarisation of assets.
• Short-Term: Debt Factoring, Invoice Discounting, Bills of Exchange, Bank Overdraft.
• Total finance (from external sources) = Long-Term finances + Short-Term finances

Raising new Share Capital

Raising “risk finance” by share capital (equity financing) involves giving away some share of ownership of the company in exchange for new funding. This is one of the most important sources of long term finance.

The stock market is the secondary market for shares that have already been issued. Most trading takes place in investment banks. But movements in the secondary market do not directly finance the company!

Advantages for a business for Listing in the Stock Exchange:

• It is easier to raise funds.
• Funds are acquired at lower cost.
• Raises profile of the company.
• Shares valued in an efficient manner.
• Broadens investor base.
• Enables other businesses to be acquired by shares rather than cash.
• It can help attract and retain employees (share incentives).

Disadvantages for a business:

• Increased cost and management time.
• Increased regulatory burden
• Close monitoring of actions and decisions
• Increased vulnerability to takeover

Two main types of share issue:

1. Rights – existing shareholders can buy more
2. Public – direct offer to public, anyone can buy.

Possible reasons for Bonus share issue:

• To improve the marketability of shares by reducing their price
• To increase lender confidence
• To signal investors the directors confidence in the future

Borrowings

Firms can also resort to borrowings (debt financing) to raise funds.

Types of Loan Capital

Term loans, Loan notes, Eurobonds, Deep discount bonds, Convertible loan notes, Junk (high-yield) bonds, Mortgages.

Factors influencing the attitude of owners towards borrowing

Risk, Return, Control, Exerting financial discipline, Debt capacity, Flexibility

Levels of gearing

• Attitude of management influenced by: Risk to income and jobs, Financial discipline that loan capital imposes
• Attitude of lenders influenced by: Profitability, Cash-generating ability, Security for the loan, Fixed cost commitments

Loan capital and risk

Lenders may reduce the risk of lending by:

• Requiring security (fixed or floating charge on assets)
• Including covenants in the loan contract

Debt factoring

• Recourse factoring – where the business assumes responsibility for bad debts
• Non-recourse factoring – where the factor assumes responsibility for bad debts

Invoice discounting

Invoice discounting is often preferred to debt factoring because:

• It is confidential
• Charges are lower
• Control over all aspects of customer relationship is retained

Leasing assets

Leasing assets involves the same concept as any individual leasing a car. The asset is not legally owned but is used by the company for which it makes lease payments. It saves the company finding capital to purchase asset. However, the company pays more than original purchase price. This is a source of assets, not actually a source of finance, and has limited application.

Long-term versus Short-term Borrowing

Considerations in Long-term versus short-term borrowing:

• Matching borrowing with assets held
• Flexibility
• Refunding risk
• Interest rates

Weighted Average Cost of Capital

The WACC is the average after tax cost of the company’s finances. This reflects the blend of how external financing has been raised. Both debt and equity.

This is often used as the discount rate when calculating the net present value of an investment. It is therefore a vital measure for decision making. It reflects the blended average cost between equity and debt used in the firm.

Related: Investment appraisal methods.

Raising finance for smaller businesses

Small businesses nowadays have access to a range of sources. However, the ease with which those funds can be procured depends on several factors such as the business model, size and stage of the business, the industry and even the economic climate.

It is also very likely that smaller businesses may face more difficulty in raising capital compared to the more established businesses. Some of the funding options may require a good credit score, collateral, or significant equity in the business.

Having said that, with careful planning and a solid business plan, small businesses can also successfully secure funding for their ventures.

Problems of smaller businesses in raising finance

• Lack of financial management skills
• Lack of knowledge concerning the availability of finance
• Inability to provide security
• Inability to meet assessment criteria of lenders
• Bureaucratic screening processes

Long-term finance for smaller businesses

• Crowdfunding
• Alternative investment market
• Government
• Business angels
• Venture capital

Private equity – types of investment: Venture capital, Expansion capital, Replacement capital, Buy-out and buy-in capital, Rescue capital.
Business angels – Make decisions quickly, Offer useful skills and experience, Expect lower financial returns.

Internal Sources of Finance

Internal sources of finance are the funds that are generated from within the business. For these funds, the company does not have to approach outside parties such as banks, shareholders, or investors.

Total Internal Finance = Short-Term + Long-Term finances

• Short-Term: Tighter credit control, Reduced inventories levels, Delayed payment to trade payables.
• Long-Term: Retained Profits

The main advantage of using internal sources of finance is that the business does not have to pay interest or share any profits with the external parties as it retains complete control over the funds.

However, businesses may still seek external sources of finance for growth or expansion.

Pecking order theory and long-term financing

The Pecking Order Theory is a concept in finance that suggests that companies have a preferred order in which they choose sources of financing. According to this theory, companies prioritize internal sources of financing, such as retained earnings, before considering external sources of financing, such as issuing debt or equity.

• Retained profits will be used to finance the business if possible
• Where retained profits are insufficient, or unavailable, loan capital will be used
• Where loan capital is insufficient, or unavailable, share capital will be used

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