2.1.2 External finance

Question 1

What are the sources of external finances?

Answer 1

• Family and friends
• Banks
• Peer-to-peer funding
• Business angels
• Crowdfunding
• Other businesses

Question 2

What are the advantages of using family and friends as a source of finance?

Answer 2

• Usually a very cheap source of funds.
• May have ‘no strings attached’ and can be provided to the business on very flexible terms.

Question 3

What are the disadvantages of using family and friends as a source of finance?

Answer 3

• Relationships may be damaged if the finance is not repaid.

Question 4

What are the advantages of using banks as a source of finance?

Answer 4

• May offer both short-term finance and long-term finance if a business qualifies.
• Banks are often keen to provide free advice and guidance to businesses that use their services.

Question 5

What are the disadvantages of using banks as a source of finance?

Answer 5

• A business plan is usually required to access bank finance.
• Banks can be cautious about lending to new, untested businesses.
• Interest is payable.
• Businesses must be customers of the bank to access some loans.
• For larger amounts, businesses may need to provide security to be granted a loan.

Question 6

What is peer-to-peer funding?

Answer 6

Individuals with available savings pool it with others in a peer investment scheme.

Question 7

What are the advantages of using peer-to-peer funding as a source of finance?

Answer 7

• Loans can usually be made available to businesses very quickly.
• Usually has ‘no strings attached’, such as a share of the business.

Question 8

What are the disadvantages of using peer-to-peer funding as a source of finance?

Answer 8

• Borrowers are charged a small fee to access finance in this way and have to pay interest.

Question 9

What are business angels?

Answer 9

Individuals that specialise in making investments in start-up or expanding businesses.

Question 10

What are the advantages of using business angels as a source of finance?

Answer 10

• They tend to be more willing to take a risk than banks.
• They often offer advice and guidance to the businesses in which they invest.
• Investment is usually for a determined period of time so owners regain shares in the future.

Question 11

What are the disadvantages of using business angels as a source of finance?

Answer 11

• Finding the ‘right’ business angel with appropriate experience, expertise or interest can be challenging.
• As business angels own a stake in the business, they will be involved in decision making and will receive a share of business profits.

Question 12

What is crowdfunding?

Answer 12

Finance provided by a large number of small investors on online platforms.

Question 13

What are the advantages of using crowdfunding as a source of finance?

Answer 13

• Creates an organic customer base and the platform provides a form of free marketing.
• A good credit rating is not required so new businesses that lack a trading record can attract funding.

Question 14

What are the disadvantages of using crowdfunding as a source of finance?

Answer 14

• Businesses need to provide a persuasive business plan to convince individuals to invest in their product as they will be competing with many other projects online.
• There is potential for negative publicity if the project is not successful in attracting enough crowdfunding capital.

Question 15

What are the advantages of using other businesses as a source of finance?

Answer 15

• May provide access to business processes and market knowledge alongside finance.
• Can access large amounts of finance.

Question 16

What are the disadvantages of using other businesses as a source of finance?

Answer 16

• Profits need to be shared between businesses.
• Decisions will usually need to be agreed by all businesses.

Question 17

What are the methods of external finance?

Answer 17

• Loans
• Share capital
• Venture capital
• Overdrafts
• Leasing
• Trade credit
• Grants

Question 18

What are the advantages of using loans as a method of finance?

Question 19

What are the disadvantages of using loans as a method of finance?

Answer 19

• Interest rates depend on the businesses credit rating.
• Non-current liabilities are increased in the balance sheet.
• With a mortgage, missed payments may lead to property being repossessed.
• Failure to repay debentures may deter investors in the future.

Question 20

What is share capital?

Answer 20

The money a company raises by issuing shares of common or preferred stock.

Question 21

What are the advantages of using share capital as a method of finance?

Answer 21

• Investors are often prepared to provide extra funding as the business grows.
• A more cost-effective way to raise finance than a loan - no interest to pay back.
• Finance is based on acquiring more equity rather than getting further into debt.

Question 22

What are the disadvantages of using share capital as a method of finance?

Answer 22

• Potential investors may require a great deal of background information before they buy the shares.
• The more shares that are sold, the more profits have to be divided up and paid out to investors as dividends.
• Can be an expensive and slow process.

Question 23

What are the advantages of using venture capital as a method of finance?

Answer 23

• Businesses that may have been refused finance from other sources may be able to attract investment from less risk-averse venture capitalists.

Question 24

What are the disadvantages of using venture capital as a method of finance?

Answer 24

• Venture capitalists usually require a stake in the business in return for finance and often expect to exert some control over the business.

Question 25

What are the advantages of using overdrafts as a method of finance?

Answer 25

- For a business owner, this would be ideal as a quick fix method to tide the business over a difficult month of trading. - An overdraft can be arranged on the phone. - The business will only pay interest on the amount of money that they are overdrawn. - As soon as the business improves trading they can easily pay back the overdraft to the bank and the interest charges will stop.

Question 26

What are the disadvantages of using overdrafts as a method of finance?

Answer 26

- If the business goes over this amount the overdraft will be 'unauthorised' and the business will be charged heavily. - A very expensive source of finance, very high charges and interest rates. - Not suitable for large amounts over a long period of time.

Question 27

What are the advantages of using leasing as a method of finance?

Answer 27

- This is a lower monthly cost for a business than a loan. - Often, business leases can be arranged without any advanced fees being paid. - The leasing firm maintain the equipment, so the business can always rely on working equipment.

Question 28

What are the disadvantages of using leasing as a method of finance?

Answer 28

- Leasing is often over a fixed term, if the business changes its mind and wants to lease from a different company, contracts may be difficult to get rid of.

Question 29

What is trade credit?

Answer 29

A type of financing in which a customer is allowed to purchase goods or services and pay the supplier at a later date.

Question 30

What are the advantages of using trade credit as a method of finance?

Answer 30

- Business can cancel the goods before the stock needs to be paid for so, can make a profit before the costs have to be paid. - No interest has to be paid on trade credit. - Businesses that pay regularly on time can build relationships with their suppliers and secure better deals.

Question 31

What are the disadvantages of using trade credit as a method of finance?

Answer 31

- Not all stock is available to buy using the trade credit method, so only applies to certain industries. - If the business does not pay in time they risk being refused further trade credit by the supplier in the future.

Question 32

What are the advantages of using grants as a method of finance?

Answer 32

- They do not need to be repaid.

Question 33

What are the disadvantages of using grants as a method of finance?

Answer 33

- The business must use the finance for its intended purpose.