3.1.3 - External sources of finance

Overdrafts and trade payables

Short-term external finance can bridge the interval between a business paying for trading activity and receiving customer cash. Two ways are a bank overdraft and supplier credit.

An illustrative café may use an overdraft to pay wages just before a delayed customer payment arrives. It can draw the amount needed rather than receive a fixed lump sum. Interest is normally charged on the amount used, with possible fees. Terms vary: a bank may change or withdraw the facility under the agreement, so it is risky to treat an overdraft as guaranteed permanent finance. A continuing overdraft can also become expensive.

Trade payables are amounts the business owes suppliers for goods or services received on credit. Supplier credit allows the business to receive supplies now and pay later. It supplies time to pay, rather than a separate cash deposit into the bank account.

In an illustrative electronics manufacturer, a supplier delivers components on 30-day credit. If the manufacturer sells finished devices and collects payment within those 30 days, customer receipts can help pay the supplier. There may be no explicit interest if the bill is paid on time, but the business may lose a discount for immediate payment. Paying late can damage supplier relations, remove future credit or interrupt supplies.

Both methods have limits. An overdraft depends on the bank's agreement and limit; trade credit depends on suppliers' willingness and payment terms. They can suit a temporary gap, but a machine used for many years may require more stable funding. Delaying a supplier payment is not the same as removing the amount owed.

Loan capital

A loan gives a business borrowed money for an agreed period, with repayment and interest obligations. It can provide a larger, more stable amount than a short-term overdraft, depending on the lender's terms.

An illustrative Peruvian food processor borrows to buy a packing machine used for several years. A loan repaid over several years can better match the machine's life than an overdraft that might be withdrawn. The lender does not normally become an owner merely by making the loan, so the existing owners retain their share of ownership.

However, repayments and interest create cash outflows even if sales disappoint. Interest rates and fees affect total cost; variable rates can increase the burden later. A lender may require security, an asset it can claim under the agreement if the borrower does not repay. Borrowing against an important asset increases the consequences of failure.

An established large business may have a stronger record and more assets to support borrowing than a start-up. That can affect access, rate and amount, but it is not automatic: lenders also examine existing debts and expected cash receipts. A low advertised interest rate does not make a loan suitable if the business cannot meet the repayment dates.

Share capital and flotation

A company can raise money by issuing shares to investors, who become part-owners. This exchanges an ownership stake for funds rather than creating an ordinary loan repayment.

Shareholders may receive dividends from profits and gain voting rights according to the shares held. Ordinary share capital does not normally require repayment on a fixed date or mandatory interest payments. This can reduce fixed repayment pressure while a long-term project develops. Dividends and ownership rights still matter to investors, so the finance is not without a cost to existing owners.

Issuing new shares can dilute control: existing owners hold a smaller proportion unless they buy enough of the new issue. An illustrative company owned entirely by two founders may bring in other shareholders to build a factory, but those investors may influence decisions and expect returns. Sole traders and partnerships do not issue company shares in the same way.

A stock market flotation is the process of offering a public limited company's shares to the public and obtaining a stock market listing. A flotation that includes a new share issue can raise a large amount from many investors, which may help finance major international expansion. Listing brings disclosure, professional-adviser costs and scrutiny; public shareholders can put pressure on management. It is a substantial process, not simply asking friends to invest.