Short-term external sources, such as bank overdrafts and trade credit, are designed to manage day-to-day cash flow and working capital needs. Trade credit allows a business to obtain goods now and pay the supplier later (typically 30-90 days), while an overdraft provides a flexible facility to spend more than the bank balance, albeit at high interest rates.
Long-term external sources are intended for major investments like property or machinery that will generate returns over many years. Bank loans provide a fixed sum with a structured repayment plan and interest, whereas share capital involves selling equity in a limited company to investors, which provides permanent capital but dilutes the original owners' control.
Hire purchase is a specific method for acquiring equipment where the business pays in installments over time. The business has use of the asset immediately but only gains full legal ownership once the final payment is made, making it a viable option for businesses that cannot afford a large upfront cost.
Purpose and Duration: The source of finance should match the 'life' of the asset being funded. Short-term needs like paying wages should be met with short-term finance (e.g., overdraft), while long-term assets like a factory should be funded by long-term sources (e.g., a mortgage or share capital).
Cost of Finance: Managers must evaluate both direct costs, such as interest rates and arrangement fees, and indirect costs like the opportunity cost of using internal funds. Debt is often cheaper than equity in terms of immediate cash flow, but it increases the financial risk of the business through fixed repayment obligations.
Control and Risk: Issuing shares may result in a dilution of control, as new shareholders gain voting rights and a say in decision-making. Conversely, taking on excessive debt increases gearing, which makes the business more vulnerable to interest rate changes and economic downturns.
| Feature | Debt Finance (e.g., Loans) | Equity Finance (e.g., Shares) |
|---|---|---|
| Ownership | No change in ownership; the lender is a creditor. | Ownership is shared; investors become part-owners. |
| Repayment | Must be repaid with interest according to a schedule. | No requirement to repay the capital; dividends are optional. |
| Cost | Interest payments are tax-deductible business expenses. | Dividends are paid from after-tax profits. |
| Control | Lenders have no say in daily business decisions. | Shareholders usually have voting rights. |
Context is King: In exam questions, always recommend a source of finance that fits the specific business scenario. A small sole trader is unlikely to use share capital (as they aren't a company), and a giant PLC shouldn't rely on an overdraft for a global expansion project.
Balanced Evaluation: When asked to 'evaluate' a source, ensure you discuss both its advantages (e.g., speed, no interest) and its drawbacks (e.g., limited amount, risk of asset loss). This demonstrates a comprehensive understanding of the source's feasibility for the business's specific needs.
Check the Numbers: If a question provides data on interest rates or current debt levels (gearing), use these to justify why one source is better than another. A business with already high debt may find it difficult or expensive to secure further loans.
Internal is not 'Free': A common mistake is assuming internal finance has no cost. In reality, using retained profit has an opportunity cost, as that money could have been used elsewhere or paid out to owners as a return on their investment.
Overdrafts as Long-term Debt: Students often suggest overdrafts for buying long-term assets. This is risky because overdrafts can be 'called in' by the bank at any time, leaving the business in a precarious position if the money is tied up in a non-liquid asset.
Grant vs. Loan: Do not confuse government grants with loans. A grant generally does not need to be repaid, provided certain conditions are met, whereas a loan is a debt that must be paid back with interest.
