Internal & External Sources of Finance (Cambridge (CIE) O Level Business Studies)

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Danielle Maguire

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Internal Sources of Finance

An internal source of finance is money that comes from within a business such as owners capital, retained profit and money generated from selling assets
An external source of finance is money that is introduced into the business from outside such as a loan or share capital

Internal sources of finance

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 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

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 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 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

Sale of stock

Stock may be sold at reduced prices in order to raise additional finance
This reduces the opportunity cost and storage cost of high inventory levels
- It must be done carefully to avoid disappointing customers if stock runs low
- E.g. A clothing retail business holds a January sale to get rid of old stock and make space for new Spring stock

Managing working capital

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 incentivise customers to pay more promptly for credit purchases

Evaluating the use of 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 often be organised 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

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 often be organised 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

External Sources of Finance

In some cases, a business may not be able to fulfil its needs with internal sources of finance
- Some projects or investments may require a significant amount of finance
- External sources, such as loans or issuing shares, can provide the necessary funds for these expensive projects

Diagram: external sources of 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

External Sources of Finance

Source	Explanation
Bank overdraft	An arrangement for business current account holders to spend more money than it has in their account Overdraft users are typically charged interest at a daily rate Using an overdraft for a long period can be expensive compared to other methods
Bank loan	A sum of money is borrowed from the bank and repaid (with interest) over a specific period of time Loans can be short-term or long-term Banks must approve the loan application Loans must be repaid with interest
Hire purchase/leasing	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 Businesses commonly use these arrangements for equipment such as company cars (leasing) or photocopiers (hire purchase)
Share issue/debentures	A company can raise finance by selling shares on the stock market This can raise large amounts of capital but requires a business to follow strict regulations A rights issue allows existing shareholders the right to buy new shares in the business to raise further finance Shares in private limited companies may be sold to venture capitalists or angel investors Venture capitalists may provide guidance and expertise as part of the arrangement Debentures are long-term loan certificates issued by limited companies Debentures must be repaid with interest to lenders
Debt factoring	Businesses can sell their accounts receivable (invoices) to a third party at a discount The third party pays the business immediately, which means that cash is received immediately Customers then pay the third party over the agreed time frame (possibly several months)
Trade credit	Where a business has an agreement to delay paying its suppliers for a period of 30, 60 or 90 days This helps to improve the cash position of the business
Grants and subsidies	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

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 use is carefully monitored

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