External finance — Edexcel A-Level Business
Test yourself on External finance with PEARSON EDEXCEL A-Level practice questions.
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External finance explained
A source is who the money comes from, which is a different question from the form it takes, and each provider prices the same pound differently because each faces a different risk.
Read the full explanation
Family and friends are quick, cheap and informal, and a default costs a relationship. Banks are the standard route, demanding a business plan, security and often a personal guarantee, which quietly undoes limited liability. Peer to peer platforms such as Funding Circle match savers to firms online, faster than a bank but at a higher rate for a weak credit record. Business angels are wealthy individuals investing their own money for equity and bringing contacts and expertise with it. Crowd funding sites raise small sums from many backers and double as marketing. Other businesses lend or invest where a supplier or customer has a strategic interest in the firm surviving.
b) Methods of finance: loans; share capital; venture capital; overdrafts; leasing; trade credit; grants
The form finance takes should match the life of the thing it buys, which is the principle that decides most of these questions. Long term assets go with loans, share capital or venture capital; short term working capital gaps go with overdrafts, trade credit or leasing. Loans carry a fixed repayment schedule and security and they raise gearing, calculated as non current liabilities divided by capital employed and multiplied by one hundred to give a percentage, with anything above about fifty per cent usually judged risky. Share capital never has to be repaid but dilutes control and commits the firm to dividends. Venture capital buys a large stake in a high growth firm and expects an exit. Overdrafts are flexible, dear and repayable on demand. Leasing spreads cost and never yields ownership. Trade credit is free unless an early payment discount is lost. Grants are free but conditional.
Your focus
- a) Sources of finance: family and friends; banks; peer-to-peer funding; business angels; crowd funding; other businesses
- b) Methods of finance: loans; share capital; venture capital; overdrafts; leasing; trade credit; grants
External finance exam tips
Marking Points
- Match the source to the stage and the size of the business, since a bank rarely lends to a start up without trading history while an angel invests precisely at that stage.
- Explain the cost of each in the right terms, interest and security for lenders, a share of ownership and future profits for angels and equity crowd funding.
- Refer to the specific evidence in the extract, such as the credit record, the amount required, the deadline and whether the owner will accept outside involvement.
- Reach a supported recommendation that compares at least two sources and states the condition on which the choice turns.
- Apply the matching principle explicitly, funding a long life asset with long term finance and a temporary shortfall with an overdraft or trade credit.
- Quantify the effect where data allows, for example how a new loan changes gearing or what the annual interest charge does to operating profit.
- Set out the control consequence of equity methods, dilution of ownership for share capital and a demanding investor with board influence for venture capital.
- Recommend one method for the named business and justify it against the size, the term, the cost and the owner's willingness to give up control.
Examiner Tips
- 💡Twelve mark questions almost always ask you to assess which source suits a named firm, so plan two sources plus a criterion for choosing between them.
- 💡Use the amount needed as your first filter; ruling out family and friends because the sum is far beyond their means is fast, evidenced application.
- 💡Where the owner has said they want to keep control, an equity source needs a strong defence, and saying so lifts the conclusion.
- 💡If a gearing or interest figure appears in the extract, the examiner intends you to calculate or comment on it, so do the arithmetic before you argue.
- 💡Structure a recommendation around amount, term, cost and control; four named criteria make a judgement look supported rather than asserted.
- 💡Remember that a private limited company cannot sell shares to the public, so ruling out a share issue on those grounds is a quick, precise application point.
Common Mistakes
- Confusing a source with a method, so an answer offers an overdraft as a source of finance when the source is the bank and the overdraft is the form.
- Treating crowd funding as easy money, when campaigns that miss their target on an all or nothing platform raise nothing and expose the idea to competitors.
- Overlooking that a bank will usually require a personal guarantee from the directors of a small company, which removes much of the protection limited liability appeared to give.
- Recommending an overdraft to buy a building, which mismatches a repayable on demand facility with a twenty year asset and usually costs more in interest.
- Claiming share capital is free because there is no interest, ignoring dividend expectations and the permanent loss of a share of future profits.
- Stating that leasing is cheaper than buying without noting that total lease payments normally exceed the purchase price and the firm owns nothing at the end.