External Sources of Finance:

Question 1

List 13 external sources of finance

Answer 1

1. hire purchase
2. owners capital
3. loans
4. crown-funding
5. mortgages
6. venture capital
7. debt factoring
8. leasing
9. trade credit
10. grants
11. donations
12. peer to peer lending
13. invoice discounting

Question 2

Define owners capital…

Answer 2

Owners capital is the money invested in the business from the owners personal savings, which is used to start or expand the business. This is a long term option (for long-term growth or stability in the business) with a few additional costs (because the owner is using their own money so there aren’t any interest or fees involved unlike borrowing money from banks or investors.)

Question 3

What does external sources of finance mean?

Answer 3

External sources of finance are those available from outside the business, it is the places where finances can be raised from outside the business.

Question 4

Define loans

Answer 4

Loan is a sum of money borrowed from a bank or financial institution that must be repaid with interest over an agreed period for a specific purpose. Interest will be payable for all loans.

Question 5

Define crown-funding

Answer 5

Crowdfunding is when a large number of people contribute small amounts of money online to support a project, business, or cause.

Question 6

Define mortgages

Answer 6

Mortgages are a long-term loan with interest (Interests are payable on mortgage because all loans have interest you must pay), normally around 25 years, that are secured against a specific asset, like a building.

Question 7

Define venture capital

Answer 7

Venture capital is money invested in a business by someone with experience, like an entrepreneur or a company, in exchange for a share (equity) of the business.

They usually invest in businesses that have the potential to grow quickly and make a lot of money. In return, they become part-owners and may help guide the business with their expertise.

Question 8

Define debt factoring

Answer 8

Debt factoring is when the business sells the money that customers owe the businesses (unpaid invoices) to a factoring company for immediate cash instead of waiting for a long time to buy more inventory. The factoring company gives the business most of the money owed (like 80%) right away. The factoring company is now in charge of collecting the money from the customers. Once the customers pay, the factoring company keeps a small fee and gives the rest of the money back to the business.

Example: Your business is waiting for £1,000 from customers.
You sell this debt to a factoring company.
They give you £800 now and collect the £1,000 from the customers later.
After they take their fee (e.g., £50), they give you the remaining £150.

Question 9

Define hire purchase

Answer 9

Hire purchase is a payment method where a buyer pays an initial deposit (a portion of the cost paid initially upfront as part of the purchase agreement), uses the goods immediately, and gains ownership only after completing regular installments (monthly payments made over a fixed period to pay off the total cost), including any interest. This is common for purchasing expensive items like cars and machinery. If the buyer fails to make payments, the seller can repossess the goods.

Question 10

Define leasing

Answer 10

Leasing is a contractual agreement where one party (the lessee) pays to use an asset owned by another party (the lessor) for a specific period, making regular installment payments, without gaining ownership. At the end of the lease term, the asset is usually returned to the lessor, unless otherwise agreed (e.g., through a purchase option).

Question 11

Define trade credit

Answer 11

Trade credit is a period of time offered by suppliers to allow the customer to purchase a good or service now and pay at a later date. For example, 30 days after the purchase. This helps businesses manage their cash flow by delaying payment for purchases.

Question 12

Define grants

Answer 12

Grants are financial awards given by governments or organizations to support specific projects and purpose, such as providing jobs in deprived areas, developing environmentally friendly technologies, or funding education and health initiatives. Unlike loans, grants do not need to be repaid.

Question 13

Donations definition

Answer 13

Donations are sums of money given by individuals, organisations, and businesses voluntarily to a charity or a social enterprise for charitable purposes.

Question 14

Define peer to peer lending

Answer 14

Peer-to-peer lending is a way for individuals to borrow and lend money directly through online platforms without banks.
Borrowers get loans from multiple lenders, who earn interest on their investment.
P2P platforms help connect borrowers and lenders, offering easier access to funds and potential higher returns for lenders.

Question 15

Define Invoice discounting

Answer 15

Invoice discounting is when a business borrows money from a lender based on unpaid invoices (money customers owe but haven’t paid yet). The business receives a percentage upfront from the lender and repays the lender, plus any interest or fees once the customer pays the invoice. This helps the business maintain cash flow.

Question 16

List advantages of owners capital

Answer 16

Owner’s capital advantages:

1. There are no repayments. Owner does not have to pay extra interest like in a loan.
2. Since there are no interest charges, it is a cost effective source of finance.
3. It allows the owner to maintain full control of the business without sharing equity with investors.
4. A significant personal investment and improved creditworthiness demonstrates commitment to the business, which attracts future external funding.
5. Owner’s capital is really quick and easy to access, it is readily available without needing lengthy application processes.

Question 17

List disadvantages of owners capital

Answer 17

1. They can have limited money so the owner can only use what they have saved, and may not be sufficient in larger investments.
2. The owner risks losing their savings if the business fails, which could impact personal financial security.
3. Unlike loan interest which is tax deductible, owners capital does not offer any tax advantages.
4. The money invested in the business could have been used for other investments or personal purposes that may yield better returns (made them more profit)
5. Solely relying on personal funds can out pressure on the owner to ensure the business succeeds.

Question 18

List advantages of loans

Answer 18

Advantages of Loans:

1. Quick Access to Funds: Loans provide a lump sum of money quickly, which can be used to grow the business, cover costs, or invest.
2. Flexible Terms: Loans often come with repayment and instalment options that can be tailored to the business’s financial situation, like fixed monthly payments.
3. Boosts Business Credit: Regular repayments can improve your credit rating, making it easier to borrow in the future since it shows lenders that you are responsible with the borrowed money.
4. Lower Interest Rates (Compared to Credit Cards): Loans generally have lower interest rates than credit cards or overdrafts.
5. Predictable Costs: Fixed interest rates mean businesses can budget repayment costs more effectively because the cost is predictable.

Question 19

List disadvantages of loans

Answer 19

1. Interest Costs:
   You must repay the loan with added interest, which increases the overall cost of borrowing overtime.
2. Risk of Collateral Loss:
   Some loans require you to offer an asset (like property or equipment) as security. If you can’t repay, the lender can seize or take these assets from you.
3. Regular Repayments Required:
   You must make regular repayments, even during financial difficulties. Missing payments can result in penalties or legal action.
4. Debt Burden:
   Having too many loans can strain cash flow and leave less money for other business activities.
5. Restrictions:
   Some loans come with conditions, like how the money can be used, which limits flexibility.

Question 20

List advantages of crown funding

Answer 20

1. Easy Way to Raise Money Without a Loan: You don’t need to borrow from a bank or pay back the money in most cases.
2. Tests Market Demand: If lots of people invest, it shows there’s interest in your product or business idea.
3. No Regular Repayments:
   For some types of crowdfunding like equity or donations, you don’t need to pay back the money.
4. Free Advertising:
   Your crowdfunding campaign spreads the word about your business or product to potential customers.
5. Different Options:
   You can choose the type of crowdfunding that suits you—like giving rewards, selling equity (shares), or accepting donations.
6. Builds a Supportive Community: People who invest might also help promote your business and become loyal customers.

Question 21

List disadvantages of crown funding

Answer 21

1. No Guarantee You’ll Raise Enough Money:
   If you don’t reach your funding goal, you might not get anything on some platforms.
2. Takes a Lot of Time:
   Creating and promoting your campaign requires a lot of effort.
3. Platform Fees:
   Crowdfunding websites charge fees, so you don’t get the full amount raised.
4. Your Idea is Public:
   Sharing your idea could lead to someone copying it.
5. Giving Up Equity:
   For equity crowdfunding, you might need to give investors a share of your business, which means less control for you.
6. Pressure from Investors:
   People who invest may expect updates, rewards, or a return on their investment.
7. Reputation at Stake:
   If your campaign fails, it could hurt your business’s image.

Question 22

List advantages of mortgages

Answer 22

Helps Buy Expensive Property:
Mortgages let you afford property by spreading the cost over many years instead of paying upfront.

Predictable Costs (Fixed Payments):
Fixed-rate mortgages mean your monthly payments stay the same, making it easier to plan your budget.

Lower Interest Rates:
Mortgages usually have lower interest rates than other loans because the house is used as collateral (security).

You Own the Property:
Once paid off, the property is entirely yours and might increase in value, building your wealth.

Improves Credit Score:
Making regular payments improves your credit rating, making it easier to borrow money in the future.

Potential for Rental Income:
If you rent out the property, you can earn money to help cover the mortgage payments.

Question 23

List disadvantages of mortgages

Answer 23

Long-Term Debt:
Mortgages last for decades (20-30 years), meaning you’re tied to repayments for a long time.

Risk of Losing Property (Repossession):
If you don’t keep up with payments, the lender can take back the house.

Extra Costs:
You’ll need to pay additional fees like a deposit, legal costs, insurance, and possibly maintenance.

Interest Adds Up:
Over time, you could pay much more than the property’s original price due to interest.

Fixed Payments:
You have to pay every month, even if your financial situation changes, which can cause stress.

Property Value Might Fall:
If the property’s value drops, you might owe more on the mortgage than the house is worth (negative equity).

Limited Flexibility:
Selling or moving is harder if the property is tied to a mortgage you’re still paying off.

Question 24

List advantages of venture capitalists

Answer 24

Large Amounts of Investment:
Venture capitalists (investors who provide funding to businesses with growth potential) can offer substantial amounts of money to help businesses grow.

Expert Guidance:
Along with money, venture capitalists bring experience and business advice to help manage and grow the company.

No Repayments:
Unlike loans, venture capital doesn’t need to be paid back because the investors take a stake (equity, meaning part-ownership) in the business instead.

Business Connections:
Venture capitalists often have a network of contacts that can help the business, like suppliers, customers, or industry experts.

Boosts Business Credibility:
Having venture capital funding can make other investors or partners trust your business more, increasing its reputation.

Question 25

List disadvantages of venture capitalists

Answer 25

Loss of Control: Venture capitalists take equity (ownership in your business), which gives them the right to influence important decisions. This means you don’t have full control over how the business is run. Profit Sharing: Since venture capitalists own a part of the business, they get a share of the profits. This reduces the amount of money you personally earn from the business’s success. High Expectations: Venture capitalists invest to make a profit, so they expect your business to grow quickly and perform well. This can put a lot of pressure on you to meet their expectations. Complex and Time-Consuming Process: Getting venture capital isn’t easy. You need to prepare detailed plans, like business strategies and financial forecasts (predictions of future earnings and expenses), and investors will carefully check every detail. This takes a lot of time and effort. Risk of Conflict: Disagreements can arise between you and the investors, especially if they want changes to the business that you don’t agree with, such as changing products or hiring new management. Exit Strategy Required: Venture capitalists expect to sell their ownership in the business (called an exit strategy) after a few years, usually to make a profit. This might force you to sell the business or go public (list shares on the stock market), even if it’s not part of your long-term plans

Question 26

List advantages of debt factoring

Answer 26

Quick Access to Cash: Businesses get money quickly instead of waiting weeks or months for customers to pay invoices. Improves Cash Flow: Helps the business manage daily operations like paying employees or suppliers without delays. Reduces Admin Work: The factoring company handles collecting payments from customers, saving the business time and effort. Supports Business Growth: The immediate cash can be used to invest in new projects, buy stock, or expand the business. No Additional Debt: Unlike loans, factoring doesn’t add debt to the business because it’s based on existing invoices.

Question 27

List disadvantages of debt factoring

Answer 27

Fees and Reduced Profits: The factoring company charges fees (e.g., 2-5% of the invoice value), meaning the business gets less money than the total invoice amount. Impact on Customer Relationships: The factoring company collects payments directly from customers, which could damage the business’s relationship with them if the process is too aggressive. Eligibility Requirements: Not all businesses qualify for debt factoring. The factoring company usually requires the customers to have a good payment history and creditworthiness. Dependence on Factoring: Relying too much on factoring can create financial dependency and limit long-term independence. Reputational Risk: If customers know a business uses debt factoring, it could make the business appear financially weak.

Question 28

List advantages of hire purchase

Answer 28

Spread Payments: The cost of the asset is divided into smaller, manageable installments, making it easier for businesses to afford expensive items. Immediate Use: The business can use the asset right away, even though they haven’t paid the full amount yet. Preserves Cash Flow: Hire purchase allows the business to keep its cash for other operational needs instead of spending it all on a large purchase. Fixed Repayments: Regular and predictable payments help with budgeting and financial planning. Access to Expensive Equipment: Small businesses or startups can acquire essential equipment without needing a large upfront investment.

Question 29

List disadvantages of hire purchase

Answer 29

Higher Overall Cost: Due to interest charges, the total amount paid through hire purchase is usually more than the asset’s original price. Ownership Delayed: The business doesn’t fully own the asset until all payments are made, so they can’t sell or modify it freely during the payment term. Risk of Repossession: If the business fails to make payments, the lender can repossess (take back) the asset. Impact on Credit: Missed payments can hurt the business’s credit score, making it harder to borrow in the future. Long-Term Commitment: The repayment period can be long, creating a financial obligation even if the business’s situation changes. Depreciation Risks: The asset might lose value over time, meaning the business could end up paying more for something worth less.

Question 30

List advantages of leasing

Answer 30

Lower Upfront Costs: The business doesn’t need to pay a large sum to acquire the asset; it pays smaller, regular amounts instead. Preserves Cash Flow: Since there’s no big upfront payment, the business can use its cash for other priorities like operations or growth. Access to Up-to-Date Equipment: Leasing allows businesses to upgrade to the latest equipment at the end of the lease term, avoiding outdated assets. Maintenance Included: Many leasing agreements include maintenance and repairs, saving the business extra costs and effort. Predictable Payments: Fixed monthly payments make budgeting easier. Tax Benefits: Leasing payments can sometimes be written off as a business expense, reducing taxable income.

Question 31

List disadvantages of leasing

Answer 31

Higher Long-Term Cost: Over time, leasing often costs more than buying the asset outright, especially for long-term use. No Ownership: The business never owns the asset, so it can’t sell or modify it as needed. Ongoing Payments: The business must keep paying as long as it uses the asset, even if it’s no longer essential. Restrictions in Contracts: Leasing agreements often have restrictions, like mileage limits for vehicles or conditions for returning the asset. Dependency on Leasing Companies: The business may become reliant on leasing instead of building long-term asset ownership. Loss of Tax Benefits Over Time: For some leases, the ability to claim tax deductions might reduce over time, depending on the agreement.

Question 32

List advantages of trade credit

Answer 32

Delays the need to pay for goods and services purchased, therefore aiding cash flow Trade credit usually doesn’t involve interest, making it cheaper. You don’t have to spend your money right away, so you can use it for other important things like paying staff or buying more stock.

Question 33

List disadvantages of trade credit

Answer 33

Not all suppliers offer trade credit, and new or small businesses may struggle to get it due to lack of trust or credit history. Payments are due within a set period, and failure to pay on time can lead to penalties or strained supplier relationships. Some suppliers offer discounts for immediate payment, which businesses using trade credit miss out on. Late payments or defaulting on trade credit can harm the business’s reputation and credit rating, making it harder to get finance in the future. A business might order more goods on credit than it can afford to pay for, leading to cash flow problems. Relying too much on trade credit from a specific supplier can create dependency and limit negotiation power.

Question 34

List advantages of grants

Answer 34

No Repayment: The best part is that you don’t have to pay the money back, so there’s no debt involved. Financial Support: Grants can provide a business with much-needed funding for specific projects, research, or growth without taking on additional financial risk. Improves Credibility: Receiving a grant can boost your business's reputation and show others that your project is worth funding. Helps Innovation: Grants often fund projects that are new, innovative, or solve important problems, allowing businesses to explore ideas without financial pressure. Attracts Other Investment: If you get a grant, other investors may be more willing to invest in your business, as it shows you're trusted by other organizations.

Question 35

List disadvantages of grants

Answer 35

Highly Competitive: Many businesses apply for grants, but there are usually only a limited number available, so it can be difficult to get one. Strict Requirements: Grants often come with strict rules about how the money can be spent. If you don’t meet the criteria, you won’t get the grant. Time-Consuming Application Process: Applying for a grant takes a lot of time and effort. You need to prepare detailed proposals, reports, and documents. Limited Funding Amount: Grants usually cover only part of the costs of a project, so you might still need additional funding sources. Uncertain Availability: Grants are often given for specific projects or times, so you may not know if there will be another opportunity in the future.

Question 36

List advantages of donations.

Answer 36

No Repayment: Like grants, donations don't need to be paid back, so you don’t have to worry about debt. Helps Fund Charitable Causes: Donations are often used to support social or charitable projects, which can make a real impact on the community or a cause. Builds Community Support: Receiving donations can help build goodwill and show that your business or cause has public support. Attracts Other Donors: If people see that your business or project is receiving donations, they may be more likely to donate as well. Flexible Use: Donations often come with fewer restrictions than grants, so you can use the money as you see fit for your cause.

Question 37

List disadvantages of donations.

Answer 37

Unpreditctable: Donations aren’t guaranteed and might not come in regularly, making it hard to plan ahead. Too Dependent on Donors: If your business or project relies too much on donations, it could struggle if people stop giving. Takes Time and Effort: Finding people to donate can take a lot of time and energy, like hosting events or campaigns. Not Always Enough: Donations might not be enough to cover all your costs, especially for big projects. Pressure to Please Donors: You might feel pressure to keep donors happy, like publicly thanking them or meeting their expectations.

Question 38

List advantages of peer to peer lending

Answer 38

Lower Interest Rates Borrowers can secure loans at lower rates compared to traditional banks, especially with good credit. Higher Returns for Lenders Lenders often earn higher returns compared to savings accounts or traditional investments. Accessibility Borrowers who may not qualify for bank loans due to poor credit or lack of collateral can often find funding. Faster Process The loan application and approval process is quicker and less cumbersome than traditional banking. Transparency P2P platforms provide detailed borrower and loan information, enabling better decision-making for both parties.

Question 39

Disadvantages of peer to peer lending

Answer 39

Higher Risk for Lenders P2P loans are unsecured, meaning there’s no collateral. If the borrower defaults, the lender could lose their money. Limited Regulation P2P lending is less regulated than traditional banks, which can lead to potential fraud or operational risks. Variable Loan Rates for Borrowers Borrowers with lower credit scores may face higher interest rates than they would at a bank. Liquidity Issues for Lenders Once money is lent, it’s tied up until the borrower repays, which can make it harder to access funds quickly. No Insurance Protection Unlike savings in a bank, investments in P2P lending are not covered by insurance, such as the Financial Services Compensation Scheme (FSCS) in the UK.

Question 40

List advantages of invoice discounting

Answer 40

Issuing Invoices: A business provides goods or services to its customers and issues invoices for payment. Applying for Funding: The business approaches an invoice discounting provider (bank or financial institution) and submits unpaid invoices. Advance Payment: The provider advances a percentage (typically 70%-90%) of the invoice value to the business. Customer Payment: Once the customer pays the invoice, the remaining balance (minus fees) is released to the business. Fee Deduction: The provider charges a fee for the service, which is deducted from the final settlement.

Question 41

List disadvantages of invoice discounting

Answer 41

Costs and Fees: Service fees and interest can be higher than traditional loans. Risk of Customer Default: If customers fail to pay, the business may be required to repay the advance. Eligibility Criteria: Providers may only work with businesses that have reputable customers and strong invoice histories. Short-Term Solution: It solves immediate cash flow issues but may not be sustainable for long-term financial needs. Impact on Profit Margins: The fees associated with invoice discounting can eat into profits.