2.1.2 - External Finance

What External Finance Means

External finance is used when a business cannot, or does not want to, rely only on finance generated from within the business. That could happen at start-up, during expansion, or when cash is tight and managers need outside support to keep trading or invest.

The most important exam distinction here is between a source and a method of finance. A source answers the question "who is providing the money?" A method answers "how is the finance being provided?" So a bank is a source, while a loan or overdraft is a method. A business angel is a source, while the method is usually share capital. If students mix those up, they often lose easy marks.

This matters because the same source can sometimes offer different methods. Family and friends might lend money or buy shares. Other businesses might help by offering trade credit or by investing for a stake. So the best answer is usually not just a list. It is a match between the business need and the form of finance.

Where Finance Comes From

Once the source-method distinction is clear, the next step is to compare the main sources named in the specification. These sources differ in how easy they are to access, how much finance they are likely to provide, and what the business may have to give up in return.

Family and friends are often the earliest external source. They may lend money quickly or buy a small stake in the business. That speed and flexibility can help at start-up, but it can also create personal tension if the business struggles and the money cannot be repaid.

Banks are a more formal source. They are most associated with loans and overdrafts, and they usually want evidence that the business can repay. That means a business plan, forecasts, or security may matter.

Peer-to-peer funding uses online platforms to connect lenders with businesses directly. It can widen access to finance when a bank is cautious, but the business still has to repay what it borrows and interest will usually be charged.

Business angels are more likely than a bank to accept risk in a new or fast-growing business. That can be valuable when the firm has potential but not much trading history. However, angels are not giving away money. In return, they usually want ownership and some influence.

Crowd funding spreads the funding across many people, usually through a website. It can work well when a business has a clear story or product that supporters can buy into. The weakness is uncertainty: if the campaign fails to attract enough people, the business may still fall short of the money it needs.

Other businesses can also be a source of finance. A supplier may effectively finance a customer through trade credit, or a larger business may invest in a smaller firm for strategic reasons. This is why source and method overlap: "other businesses" tells you who the finance comes from, but the method still has to be named separately.

Borrowing And Cash-Flow Methods

Several external methods help a business keep full ownership because the money is not raised by selling shares. The trade-off is that these methods usually create repayment commitments or regular charges. If cash inflows weaken, the finance that once helped the business can quickly become a pressure point.

A loan is usually the better fit when a business needs a planned amount of money for more than a very short period. The business borrows a sum, pays interest, and repays it over time. That can make a loan suitable for equipment, refurbishment, or expansion where managers can forecast the returns. The risk is straightforward: the repayments still have to be made even if sales disappoint.

An overdraft is more flexible than a loan because the business uses it only when needed, and interest is charged only on the amount overdrawn. That makes it useful for a short-term cash-flow gap. However, overdrafts can carry higher interest or fees than loans and can be withdrawn by the bank, so they are risky as a long-term solution.

Leasing allows a business to use an asset such as machinery, vehicles or equipment without buying it outright. This reduces the initial cash outflow and can help a business access assets sooner. The cost is that the business makes regular rental payments and may pay more in total over the life of the contract.

Trade credit supports day-to-day trading rather than major investment. If a supplier gives 30 to 90 days before payment is due, the business can sell some stock before it has to hand over the cash. That eases short-term cash timing and helps working-capital management; obtaining stock on credit does not itself increase net working capital because inventory and trade payables both rise. But if the firm relies on trade credit too heavily, supplier relationships may weaken and late-payment problems can build.