External Sources of Finance
Bank Loans provide a lump sum for a fixed period with regular repayments and interest. They are often secured against business assets (collateral), which reduces the interest rate but increases risk if the business defaults.
Debentures (Bonds) are long-term loan certificates issued by a company to the public or institutions. The company pays a fixed rate of interest (coupon) and must repay the principal at the end of the term.
Mortgages are specialized long-term loans specifically for purchasing property or land. The property itself serves as security for the loan over a duration typically spanning 15 to 25 years.
Share Capital is raised by selling shares to investors. Unlike debt, this capital does not need to be repaid, and dividends are only paid if the business is profitable and chooses to distribute them.
Venture Capital involves high-risk investment from specialist firms into small or medium businesses with high growth potential. In exchange for funding, venture capitalists usually require a significant ownership stake and a say in management.
New Partners can be brought into a non-corporate business structure to provide capital. This avoids interest payments but requires sharing future profits and decision-making power.
Leasing allows a business to use an asset (like machinery) without owning it, paying a periodic fee. This avoids large upfront costs and ensures the business can upgrade to newer technology easily.
Hire Purchase is a system where a business pays for an asset in installments. Ownership only transfers to the business once the final payment is made, making it a form of secured credit.
Micro-finance provides very small loans to entrepreneurs who lack collateral or credit history, often in developing regions. Crowdfunding raises small amounts of capital from a large number of individuals via online platforms.
| Feature | Debt Finance | Equity Finance |
|---|---|---|
| Repayment | Mandatory at fixed intervals | No mandatory repayment |
| Cost | Fixed or variable interest | Dividends (discretionary) |
| Control | No loss of ownership | Dilution of ownership/control |
| Risk | High (risk of insolvency) | Low (no legal obligation to pay) |
| Tax | Interest is tax-deductible | Dividends are paid from profit |
The Matching Principle: Always check if the duration of the finance matches the asset. Using a short-term overdraft to buy a long-term factory is a classic mistake that leads to liquidity crises.
Gearing Analysis: Consider how much debt a business already has. High gearing (high debt-to-equity ratio) makes it harder and more expensive to secure further external loans.
Collateral Awareness: Remember that most long-term debt requires security. If a business has no fixed assets to offer as collateral, it may be forced toward equity or unsecured (higher interest) options.
Control vs. Cost: In exam scenarios, if the owner wants to keep 100% control, avoid suggesting venture capital or new partners; look toward debt or leasing instead.