A business can grow by either using internal or external sources of finance. Internal sources of finance include all net cash flows generated by the business, such as retained profit or sale of assets. External sources of finance include bank loans, sale of a part of the business to investors (e.g., venture capital firms), and leasing (long-term renting of equipment). External sources of finance have a number of big advantages over the internal financing options.
A business needs investments to grow. Even the most profitable companies cannot rely solely on reinvested profits to finance their expansion. Accordingly, a business needs to secure bank credit, partner with venture capital firms or in any other way tap external sources of finance. External finance provides the room for faster growth, allowing the company to operate on a far bigger scale, capturing new markets and providing products and services to an ever greater number of customers.
Greater Economies of Scale
Large businesses are generally more efficient than small ones. They have a greater bargaining power with suppliers and they can spread their fixed costs, such as administrative expenses, over larger sales. This results in lower costs per unit of production, which, in turn, gives the company a competitive edge in the marketplace. External sources of finance help a company grow faster, achieving the economies of scale necessary to compete with the rival firms on regional, national, or even international level.
External sources of finance also leverage the returns for the entrepreneur. If, for example, an entrepreneur starts a business with the return on investment rate of about 20 per cent, providing £65k of her own money as the seeding capital, then, if no external sources of finance are used, her return should be about £13k (20 per cent * £65k) a year. If, on the other hand, she takes a bank loan with an interest of 10 per cent in the amount of another £65k, then the overall return from her business will be £130k * 20 per cent = £26k, of which £6k will be the bank's interest ($100k * 10 per cent). The leveraged return our entrepreneur will get is, then, £19k, or £6k less than would have been if she didn't employ the external sources of finance.
As you can see from this example, it makes sense to use external sources of finance if the cost of capital is less than the returns generated by the business.