Sources of Finance (AQA GCSE Business)

Internal Sources of Finance

• An internal source of finance is money that comes from within a business

The Main Sources of Internal Finance

• Business owners often prefer using internal finance as it avoids having to pay interest on borrowing or dilution of control by selling shares

Personal savings

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

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

  • 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

• Retained profit is the surplus of revenue over costs that has been generated in previous years and not distributed to owners

  • 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

Selling assets

• Selling non-current assets that are no longer required (e.g. machinery, land, buildings) generates 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 a non-current 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 was 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

• Businesses may also sell inventory at reduced prices in order to raise additional finance

  • This reduces the risk and storage costs of holding large volumes of inventory

  • It must be done carefully to avoid disappointing customers if inventory runs low

    • E.g. Clothing retail businesses commonly hold January sales to get rid of old inventory and make space for new Spring product lines

• If a business has sufficient internal finance, it is often preferable to using external sources

Evaluating Internal Sources of Finance

External Sources of Finance

• An external source of finance is money that is introduced into the business from outside 

  • External finance is used when a business cannot fulfil its needs with internal sources of finance

The Main Sources of External Finance

• The implications of the different types of external finance need to be carefully considered

  • Interest and fees to arrange finance can vary significantly between financial providers

  • The percentage of company ownership required in exchange for finance depends on how much risk investors are willing to take

  • The length of time allowed to repay borrowings or achieve investment targets also varies

Overdrafts

• An overdraft is a flexible arrangement for a business current account holder to spend more money than they have in their account

• Some large businesses rely heavily on overdrafts to manage working capital

  • A limit is agreed upon, and interest is charged only when a business ‘goes overdrawn

  • Overdraft users are typically charged interest at a daily rate

    • Using an overdraft for a long period can therefore be expensive compared to other methods

  • An overdraft may be ‘called in’ if the bank is concerned about a business's ability to repay what it owes

    • This means that the overdraft facility is no longer available for a business to use

Trade credit

• Trade credit is where a business has an agreement to delay paying suppliers for a typical period of 30 to 90 days

  • This helps to improve the cash flow position of the business 

  • Trade credit is usually interest-free

  • Large businesses tend to be able to request more generous trade credit terms from suppliers than small businesses

  • However, businesses using trade credit may miss out on early payment discounts

  • Trade credit is not normally available to new customers

Finance from loans

• A sum of money is borrowed from a bank or other financial provider and repaid with a fixed interest rate over a specific period of time 

  • The loan application must be approved before funds are transferred to the business

    • This may require a convincing business plan containing financial forecasts

    • Some financial providers demand collateral before a loan is granted

  • Long-term loans, known as mortgages, are used to fund the purchase of buildings and land

    • Repayment is in installments, typically over a long period of 25 or more years

    • Mortgages often have variable interest rates, so the cost of repayments can fluctuate

Finance from selling shares

• A private limited company can raise finance by selling shares to friends, family or private investors such as business angels

  • Ownership can be limited to those with a personal interest in the business

• Public limited companies can raise large amounts of finance through the initial sale of shares during stock market flotation or through a rights issue

  • Ownership of a business is diluted across a large number of shareholders

• Debentures are long-term loan certificates issued by limited companies to shareholders

  • Debentures must be repaid with a fixed rate of interest to lenders

• Venture capitalists may invest technological expertise, financial advice and management experience in return for a share in the business

  • Their investment is usually made for a fixed period of time, typically four to six years, during which they expect their investment to have gained value

Hire purchase

• Instead of purchasing and owning assets outright, businesses can opt to lease or use hire purchase agreements

  • A business acquires equipment such as machinery or vehicles, spreading the cost of its use over time

    • This is not a method to raise capital but allows the business use of an asset they would otherwise need to purchase

    • A business does not own the assets that are leased, and only owns hire-purchase assets once the final payment is made

• Businesses commonly use these arrangements for equipment such as company cars (leasing) or photocopiers (hire purchase)

Government grants

• These are sums of money provided to the business by governments and some outside agencies

  • They do not usually have to be repaid

  • The money is often provided with certain conditions attached, such as the business must locate in a particular area in order to create jobs

  • Obtaining grants can be quite difficult, as many businesses compete for the same limited finance

Other external sources of finance

• Businesses also access finance through the use of credit cards or charge cards

  • These are particularly useful as a means to allow employees to make small purchases that are centrally paid

  • Interest charges can be high so their use is carefully monitored

Choosing Appropriate Sources of Finance

• There are many factors that managers must consider before deciding upon the type and source of finance required

  • They may need to use more than one source of finance at the same time

Diagram: factors affecting the choice of finance

Factors including timescale, cost, purpose, and the level of existing debt affect the choice of finance

• Finance managers frequently have to make recommendations to their CEOs about the most suitable form of financing to use

An Explanation of the Factors Affecting the Choice of Finance