The Differences Between Internal And External Sources Of Business Finance Finance Essay
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Published: Mon, 5 Dec 2016
Businesses require financing in order to operate. The source of this finance can be either internal or external and furthermore it can further subdivided into long or short term. Long terms sources are those that provide finance for more than a year while short term provide for less than a year; Internal sources of finance come from within the business and “do not require the agreement of anyone beyond directors and managers of the business.” (LOE 2010:317). The long term sources of internal finance include retained profits while short term sources include selling of inventories, extending period of credit from suppliers and stricter credit control over funds owed by credit customers (LOE 2010). Sources of finance are considered short term because they can easily be reversed in the short run. External sources of finance on the other hand “require(s) the compliance of potential shareholders” (LOE 2010:317) and in this case the company owes “outside” institutions or individuals (Brindley 2008). According to LOE (2010), long term sources of external sources of finance include ordinary shares, preference shares, long term loans, finance leases, hire purchase agreements etc. While short term sources of external finance include bank overdrafts, debt factoring and invoice discounting.
Difficulties SMEs face in raising adequate finance:
SMEs face numerous challenges in raising enough finance for their business. According to Propoarco (2009:13) “difficulties in gaining access to financing constitute the main stumbling block for SME development in Sub Saharan African.” This is caused by a number of factors. First, there are inadequate personal funds and resources to fully fund the business and this requires that they look for external sources of finance where they are likely to encounter further challenges.
Lack of collateral – Banks require guarantees in the form of assets, forecast of business growth etc in order to approve long and short term loans and ensure that they can get their money back through payments or by selling off the defaulter’s assets. Unfortunately most SMEs do not have many assets in the business’ name as they are start ups and this poses challenges. Moreover, because some SMEs are sole proprietorships, it can be difficult to separate the SME’s assets from those of the business owner (oecd.org). Banks are therefore weary of providing funding where there is no clarity especially when it is unclear regarding the health of the business and its assets. There is no guarantee that the SME can sustain loan payments.
High Cost of finance, Too high interest rates that are unsustainable. SMEs are considered high risk because they have a high failure rate and therefore more likely to default on loans (ITC 2009). As such, in order to counter their risk of lending to such enterprises, banks charge high interest rates. This in turn makes access to funding expensive for SMEs compared to larger organisations that are not viewed as high risk.
SME owners sometimes lack access to information regarding where to access funds and may not be aware of the requirements in order to access these funds ITC 2009). Moreover SME may not have a clear and well constructed business plan that details the business’ path over the next few years; a key requirement for most financing institutions; or the business plan may be poorly constructed and not have key information (oecd.org). In addition banks may require pertinent information such as credit rating, credit history in order to make well informed decisions. Unfortunately as a start up, an SME might not have this information. Moreover the company may not have kept this information or the company’s funds may be intertwined with the owner’s personal finances, making it difficult to produce this information. Such regulatory constraints make it challenging for SMEs to access financing.
The loan application process itself may be too lengthy and complicated such that the SME owner gives up (ITC 2009).
SMEs can also be pessimistic about outside investors and would rather “keep it in the family.” As such they are not open to financing ideas that involve outsiders taking part ownership or control of the companies. This therefore limits their financing options.
Possible Advice and Solutions
SMEs have several options regarding where and how to access funding.
SMEs can access finance through venture capitalists. These are individuals who provide funding to start up companies with exciting ideas that promise high returns and they offer funding to start ups, to businesses that need to achieve a turnaround, that need to expand etc(LOE 2010). However in certain cases venture capitalists may require equity or control in the said business in return.
Non- governmental organisations (NGOs) have also devised programmes in order to provide funding for SMEs because of the difficulties of accessing fund in the mainstream. Oikocredit an NGO in Ghana for example offers funding for SMEs (Mensah 2004). USAID Development credit authority also provides funding for SMEs.
Governments have also taken interest in this issue and through initiatives such as Small firm loan guarantee scheme in the UK (LOE 2010: 357) and Africa Development Bank, governments help SMEs that lack security to access funds by being the guarantors of a large percentage of the loan. Grants and subsidies are also available for example through the Ministry of SMEs in Zimbabwe.
Listings on alternative stock exchanges such as Altx in Johannesburg (RHPS.com) and AIM in the UK allow smaller businesses to list and float shares with less stringent requirements thereby raising equity finance.
Wealthy individuals, already successful in business, called business angels (LOE 2010) invest in SMEs through a shareholding to assist start ups or SME expansion plans. This can be in the form of a single individual or a consortium. While they don’t get involved in the day to day operations of the business, they do take an active interest. And can be a valuable source of business skills and experience.
According to ITC (2009), trade credit (where collateral is not required) and cash advances from customers can be short term source of finance for SMEs.
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