Sources of Internal and External Finance
Sources of Internal and External Finance
All businesses need money to function sufficiently. Where this money comes from is defined as sources of finance. There are two different types of sources of finance: internal (capital from inside the business) and external (capital from outside the business). New businesses starting up need money to spend in long-term assets such as premises and equipment. They also need cash to pay for materials, pay wages, and to pay the day-today- bills such as water and electricity. In-experienced entrepreneurs often underestimate the capital needed for the everyday running of the business; this is the reason many businesses fail due to cash flow issues even when profitable.
Internal sources of finance can be found in existing capital of the business, which can be made to stretch further. Also the business could use their own or their family’s savings to set up the business; however this could be difficult because if the business goes bankrupt no capital would be returned to the savings which could lead to family arguments. The business may be able to negotiate to pay its bills later, they can work at getting cash in advance from customers; the average small business waits 75 days to be paid; if that period of time could be halved, it would offer a huge increase to cash flow. There is also profit, as more than 60% of business investments comes from reinvested profit which is the cheapest form of investment as there are no investment charges.
If a business needs to make more finance and can’t internally, they may seek external sources of finance. There are two main types of this, loan capital and share capital. The most common way to receive loan capital is through borrowing from a bank. This can be in a form of an overdraft or loan and is more often than not set over a period of time. Loans could be short (i.e. 2-3 years), medium (i.e. 3-5 years) or long term (i.e. 5+ years).
The disadvantages of these are that there will be an interest rate on the loan, either fixed or variable. The bank will demand collateral to provide security in case the loan cannot be repaid. An overdraft is basically a very short-term loan. This lets the business be overdrawn to what extent is agreed. Overdrafts have a much greater rate of interest than loans; this therefore shows that these should only ever be used for a short-term cash flow problem. Also overdrafts can only be used for existing businesses and not new starters.
On the other hand, if the business is a limited company, it may look for extra share capital. This could come from private investors or venture capital funds. Venture capital providers are interested in investing in businesses with dynamic growth prospects. They are willing to take a risk if a business fails, or does well. The way it works is that is a venture capitalist invests in ten businesses, five could collapse, four do okay and one does amazingly well. (Peter Theil, the original investor in Facebook, turned his $0.5 million investment into $200 million: a good profit of 39,900 %.)
Once the business has become a public limited company, it can float onto the stock exchange where it can sell shares to the public. Whereas venture capital would be an easy way to receive money (advantage), I do see why people wouldn’t use this method because, rather than being their own boss and having easier decisions on their own, they would receive guidance from someone with better knowledge of how businesses succeed and fall. Plus the majority of profit would go directly to the owner and not have to be shared out to venture capitalists (disadvantage).
Dial-a-do, my business, would seek capital from both internal and external sources of finance. This is because with internal capital you can only receive a limited amount of money during a limited amount of time to start up a business, but also investing in external sources of finance would be necessary.
Investing into the business with my own capital would be a good way to start off the business; this is because profit can give a return for investors in which investors can plough back into the business to help it grow. It also does not have associated costs, and doesn’t have to be repaid, unlike loans, and finally it has no interest charges. On the other hand, investing into the business may be limited which will constrain the rate at which the business expands, as mine and my families resources are limited and wouldn’t meet start-up costs.
Investing in external sources of finance can include using bank overdrafts, loans and venture capitalists, all of which my business would use. Bank overdrafts are good because my firm would only need to borrow as much as it requires when it needs it most. But the disadvantage can include it being very expensive and banks can insist being repaid within 24 hours which can be a problem. Therefore this is mainly going to be used for occasional cash flow problems, for example over tight times e.g. January and February. I would also use loans, as these can be secured quickly and used in a large number of ways. However borrowing too much money can lead to decreased cash flow and payments can even overtake income in some cases.
Venture capital’s would also be a very good way to source finance externally, this is because usually want to contribute to the running of the business and bring in new experience and knowledge which could be vital to help the business grow. Whereas, they may require a substantial part of the ownership of the company, which could be a disadvantage because they would be receiving a substantial percentage of profit and their ways of running the business may be different to my own therefore clashing opinions, however their money would be vital for running the business to get it started up.
University/College: University of California
Type of paper: Thesis/Dissertation Chapter
Date: 23 December 2016
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