What is the primary difference between Debt and Equity finance regarding repayment?

Debt finance requires mandatory repayment of the principal plus interest regardless of profit levels. Equity finance does not require repayment of the capital, as investors receive returns through dividends and capital gains.

How does an Overdraft differ from a Bank Loan?

An overdraft is a flexible, short-term facility used for daily cash flow where interest is only paid on the amount borrowed. A bank loan is a fixed sum for a set period with a structured repayment schedule and usually lower interest rates than an overdraft.

When should a business choose Leasing over Purchasing an asset?

Leasing is preferable when a business wants to avoid a large upfront capital outlay or when the asset (like IT equipment) depreciates quickly and needs frequent upgrading. It shifts the burden of maintenance and obsolescence to the lessor.

What is the danger of using short-term finance for long-term capital projects?

This creates a maturity mismatch. Short-term sources like overdrafts can be withdrawn at short notice, leaving the business unable to fund the long-term asset and potentially leading to a liquidity crisis or insolvency.

Why is it a mistake to assume that 'Grants' are entirely free money?

While grants do not need to be repaid, they are usually conditional. Businesses must meet specific criteria (e.g., creating jobs in a specific area), and failure to meet these conditions can result in the grant being clawed back.

What is the risk of 'Over-gearing' a business?

Over-gearing occurs when a business takes on too much debt relative to its equity. This increases the risk that the business will be unable to meet fixed interest payments during a downturn, leading to bankruptcy.

Define 'Venture Capital'.

Venture capital is long-term equity finance provided by professional firms to high-growth, high-risk startups. In exchange for capital, they take a significant ownership stake and often a seat on the board of directors.

What is 'Trade Credit'?

Trade credit is a short-term source of finance where suppliers allow a business to delay payment for goods or services for a set period (usually 30, 60, or 90 days). It helps manage working capital without incurring interest.

What are 'Debentures'?

Debentures are a type of long-term debt instrument issued by a company to the public or institutions. They typically carry a fixed rate of interest and are often secured against the company's assets.

Why is Equity Finance often called 'Patient Capital'?

It is called patient capital because, unlike debt, there is no fixed repayment date or mandatory interest. Investors are willing to wait for the business to grow and generate profits before receiving returns through dividends or a future sale.

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2. Managing Business Activities

External Finance

Summary

External finance encompasses all capital raised from sources outside of a business entity. It is a critical component of corporate strategy, used to bridge the gap between internal cash flow and the capital requirements for growth, asset acquisition, or liquidity management. The selection of external finance depends on the matching principle, cost of capital, and the desired level of ownership control.

1. Definition & Core Concepts

External Finance refers to funds obtained from third-party individuals or institutions rather than from the business's own retained earnings or asset sales.
It is categorized primarily by duration (short-term vs. long-term) and nature (debt vs. equity).
Common sources include commercial banks, private investors (Business Angels), venture capitalists, and trade suppliers who provide credit terms.
The choice of source is often dictated by the business's legal structure, as limited companies have access to share capital while sole traders rely more on personal loans or overdrafts.

Flow diagram showing external finance sources (Banks, Investors, Suppliers) providing capital to a central business entity.

2. Underlying Principles

The Matching Principle: This fundamental rule states that the term of the finance should match the life of the asset. For example, a 20-year mortgage should fund a building, while a 30-day trade credit should fund inventory.
Cost of Capital: Every external source has a cost, either in the form of interest payments (for debt) or diluted earnings/dividends (for equity).
Risk-Return Tradeoff: Lenders and investors demand higher returns for higher-risk businesses. Startups often pay higher interest rates or give up larger equity stakes than established firms.
Gearing (Leverage): This measures the proportion of a business's capital that is provided by debt. High gearing increases financial risk because interest must be paid regardless of profit levels.

3. Methods & Techniques

4. Key Distinctions

5. Exam Strategy & Tips

6. Common Pitfalls & Misconceptions