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

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

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

• 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