22-09-2012, 11:35 AM
External Sources of Finance
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Personal Savings
This mainly applies to sole traders and partnerships. Owners may use some of their own money as capital to invest in the business. For instance, a person may be made redundant by a company that needs to reduce in size. They would receive redundancy payment that they might use to start their own business.
This is considered an external source as it is assumed that the money lent to the business will be paid back to the private individual in the future, possibly with an extra amount to compensate the individual for the help they gave. It can be a short or long term source of finance, depending upon the amount invested and the decision of the person using their savings.
Commercial Banks
We tend to consider two types of finance that banks offer to businesses, overdrafts and loans.
If a business spends more money than it has in its bank account, we say that it has become overdrawn. Businesses will often have an arrangement with the bank whereby the bank will pay the extra money provided the business will pay them back in a fairly short period of time, with interest. This is a short term source of finance and is useful for small amounts. It is often used for buying supplies / inputs.
A bank loan is a long term source of finance and will often be for much larger sums of money. A loan is useful for a business that is starting up or looking to grow. Loans are often used to buy fixed assets (see balance sheets) such as machinery and vehicles. A business will pay the bank back each month in instalments and will also pay an interest charge.
Share Issue
An important source of finance for limited companies. A share issue involves a business selling new shares that entitle the shareholders to share in the control of the business. Each share gives the shareholder a vote on the direction of the company. This usually means that the shareholder can elect the board of directors of the company each year. If the shareholder doesn't like the way the directors are running the business, they can elect new directors. This is a good incentive to the directors to run the business well and make a profit which will be paid to the shareholders in the form of dividends.
The more shares a person holds, the more control they have over a company. If one company wanted to take another company over, it could arrange to buy over 50% of that company's shares. This would give it a majority of control and, therefore, ownership.
Issuing new shares can raise a lot of capital that can be used for expansion (buying more fixed assets, etc). It is a long term source of finance. If the total number of shares rises, the votes of existing shareholders will have slightly less significance and they will have less control. The business will also have to pay dividends on a larger number of shares.