Available Sources of Internal and External Finance
- Personal savings: This is most often an option for small businesses where the owner has some savings available to use as they wish.
- Retained profit: This is profit already made that has been set aside to reinvest in the business. It could be used for new machinery, marketing and advertising, vehicles or a new IT system.
- Working capital: This is short-term money that is reserved for day-to-day expenses such as stationery, salaries, rent, bills and invoice payments.
- Sales of assets: There may be surplus fixed assets, such as buildings and machinery that could be sold to generate money for new areas. Decisions to sell items that are still used should be made carefully as it could affect capacity to deliver existing products and services.
- Shares: Limited companies could look to sell additional shares, to new or existing shareholders, in exchange for a return on their investment.
- Loans: There are debenture loans, with fixed or variable interest, which are usually secured against the asset being invested in, so the loan company will have a legal shared interest in the investment. This means that the company would not be able to sell the asset without the lender’s prior agreement. In addition the lender will take priority over the owners and shareholders if the business should fail and the cost will have to be repaid even if a loss is made.
There are other types of loan for fixed amounts with fixed repayment schedules. These may be considered a little more flexible than debenture loans.
- Overdraft: A bank overdraft may be a good source of short-term finance to help a business flatten seasonal dips in cash-flow, which would not justify or need a long-term solution. The advantage here is that interest is calculated daily and an overdraft is therefore cheaper than a loan.
- Hire purchase: Hire purchase arrangements enable a firm to acquire an asset quickly without paying the full-price for it. The company will have exclusive use of the item for a set period of time and then have the option to either return it or buy it at a reduced price. This is often used to fund purchases of vehicles, machinery and printers.
- Credit from suppliers: Many invoices have payment terms of 30 days or longer. A company can take the maximum amount of time to pay and use the money in the interim period to finance other things. This method should be treated with caution to ensure that the invoice is still paid on time or else the firm might risk upsetting the supplier and jeopardise the future working relationship and terms of business. It should also be remembered that it’s not ‘found’ money but rather a careful balancing act of cash-flow.
- Grants: Grants are often available from councils and other Government bodies for specific issues. For example there may be a council priority to regenerate a particular area of a town and who are happy to help fund refurbishment of buildings. Alternatively there may be an organisation that specialises in helping young entrepreneurs to launch new businesses. Assessment for grants can be very competitive, is very individual and not automatic.
- Venture capital: This source is most often used in the early stages of developing a new business. There may be a huge risk of failure but the potential returns may also be big. This is a high risk source as the venture capitalist will be looking for a share in the firm’s equity and a strong return on their investment. However the significant experience these investors have in running businesses could prove valuable to the company. This is what the TV programme ‘Dragon’s Den’ is all about!
- Factoring: This involves a company outsourcing its invoicing arrangements to an external organisation. It immediately allows the company to receive money based on the value of its outstanding invoices as well as to receive payment of future invoices more quickly. It works by the firm making a sale, sending the invoice to the customer, copying the invoice to the factoring company and the factoring company paying an agreed percentage of that invoice, usually 80% within 24 hours. There are fees involved to cover credit management, administration charges, interest and credit protection charges. This must be weighed up against the benefit gained in maximising cash flow, a reduction in the time spent chasing payments and access to a more sophisticated credit control system. The downside is that customers may prefer to deal direct with the company selling the goods or services. In addition ending the relationship could be tricky as the sales ledger would have to be repurchased.
Money is a scarce resource and each source has its own advantages and disadvantages. Lenders will be looking for a return on investment, the size of the risk and the flexibility with which they can get their money back when they want or need it. For the company seeking money, the decision as to the best source will ultimately depend on what the money is for, how long the money is needed for, the cost of borrowing and whether the firm can afford the repayments.