Internal Finance (Edexcel A Level Business)

Revision Note

An Introduction to Sources of Finance

  • All businesses need finance to get started, allow them to grow and fund their continuing activity 

  • Finance may be needed for capital expenditure, which is spending on fixed assets such as equipment, buildings, IT equipment and vehicles

  • Similarly, finance is required for revenue expenditure, which is spending on raw materials or day-to-day expenses such as wages or utilities 

  • Businesses have different sources of finance available to them

    • When the finance comes from inside the business, it is called an internal source of finance

    • When the finance comes from outside the business, it is called an external source of finance

Sources of Internal Finance

  • Internal finance comes from the owner’s capital, retained profit, or the sale of assets

Owner’s capital: personal savings

  • Personal savings are a key source of funds when a business starts up

    • Owners may introduce their savings or another lump sum e.g. money received from a redundancy payment

  • Owners may invest more as the business grows or if there is a specific need, e.g. a short-term cash flow problem

Retained profit

  • The profit that has been generated in previous years and not distributed to owners is reinvested back into the business

  • This is a cheap source of finance, as it does not involve borrowing and associated interest and arrangement fees

  • The opportunity cost of investing the money back into the business is that shareholders do not receive extra profit for their investment

Sale of assets

  • Selling business assets which are  no longer required (e.g. machinery, land, buildings) generates a source of finance

  • A sale and leaseback arrangement may be made if a business wants to continue to use an asset but needs cash

    • The business sells an asset (most likely a building) for which it receives cash

    • The business then rents the premises from the new owners

    • E.g. In early 2023, Sainsbury’s announced that it is in talks to sell the prime retail property for £500 million, which will then be leased back to them by the new owners, LXi Reit

  • A business can also generate additional finance internally by managing its working capital more effectively

    • They can negotiate extended payment terms with suppliers

    • They can encourage customers to pay more promptly for credit purchases

The Benefits & Drawbacks of Using Internal Finance

Advantages

Disadvantages

  • Internal finance is often free (e.g. it does not involve the payment of  interest or charges)

  • It does not involve third parties who may want to influence business decisions

  • Internal finance can usually be organised very quickly and without significant paperwork

  • Businesses that may fail credit checks (necessary for a bank loan) can access internal finance sources more easily

  • There is a significant opportunity cost involved in the use of internal finance, e.g. once retained profit has been used, it is not available for other purposes

  • Internal finance may not be sufficient to meet the needs of the business

  • Using an internal finance method is rarely as tax-efficient as many external methods, e.g. loan repayments may be treated as a business cost and offset against tax

 

Examiner Tip

Businesses that have been recently established or own few assets, as well as more established businesses that have made modest profits in recent years, will struggle to raise internal finance.

Weighing up the circumstances of the business is very important when considering the recommendation of internal finance.

Carefully consider the financial information that is presented within the case study material (e.g. cash flow forecasts, statements of financial position and statements of comprehensive income) and look for clues in the body of the case studies text such as the personal circumstances of the business owner or the nature of the business itself.

Then make justified assumptions about the likelihood of internal finance being suitable for the intended purpose.

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