Unit 2 (AS) Finance: Sources of Finance
Welcome to this guide on Sources of Finance! Every single business, from a local bakery to a multinational corporation, needs money to start up, manage daily operations, and expand. In your OxfordAQA International AS Business (9725) Unit 2 exam, you will need to demonstrate knowledge of different finance options, evaluate their advantages and disadvantages, and recommend suitable choices for various business contexts.
Cross-reference: While this chapter focuses on where finance comes from, operational tools that forecast cash movements and calculate profitability are covered in our companion chapters on Profit and cash and Break-even analysis.
---1. Understanding Business Finance: The Basics
Before diving into specific sources, let's understand why a business needs finance and how we classify different funding methods.
Why Do Businesses Need Finance?
Businesses require finance for three primary reasons:
1. Start-up capital: The initial money needed to establish a business (e.g., buying equipment, renting premises, and initial inventory).
2. Working capital: The day-to-day running costs needed to pay for raw materials, utility bills, and employee wages while waiting for customers to pay.
3. Expansion / Growth capital: Medium- to long-term funding required to open new branches, develop new products, or purchase larger machinery.
Time Horizons: Short-Term vs. Medium-Term vs. Long-Term
Matching the source of finance to the purpose is one of the most important principles in business:
• Short-term finance: Needed for immediate operational needs, usually repaid within up to 12 months (e.g., bank overdraft, trade credit).
• Medium-term finance: Typically spans from 1 to 5 years, often used to acquire vehicles or machinery (e.g., leasing, medium-term bank loans).
• Long-term finance: Lasts for more than 5 years, used to purchase major non-current assets like land and buildings or to fund major expansions (e.g., share capital, retained profit, long-term mortgages).
Rule of thumb: Never use short-term finance (like an overdraft) to buy long-term non-current assets (like a factory). That is a recipe for a cash flow disaster!
Internal vs. External Finance
• Internal finance: Money generated from within the existing resources of the business itself without taking on external liabilities or outside owners.
• External finance: Money obtained from individuals, institutions, or investors outside the business.
Key Takeaway: The choice of finance depends entirely on the purpose, the time horizon, and whether the business has sufficient internal funds available.
---2. Internal Sources of Finance
Internal sources do not increase debt or dilute ownership, but they are limited to what the business already owns or generates.
A. Retained Profit
This is profit that is kept within the business after paying cost of sales, operating expenses, interest, and taxes (and any dividends to shareholders). It is reinvested back into the business.
• Advantages:
- No interest payments: Unlike loans, retained profit does not incur regular interest charges.
- No dilution of ownership: No new shares are issued, so existing owners keep total control.
- Flexibility: Management has complete freedom over how the funds are used.
• Disadvantages:
- Only available to profitable, established firms: Start-ups or loss-making firms cannot use it.
- Shareholder conflict: Retaining profit means paying smaller dividends, which might frustrate shareholders seeking immediate returns.
- Opportunity cost: Once spent, that cash cannot be used for unexpected emergencies.
B. Sale of Assets
A business can raise money by selling non-current assets it no longer requires (such as surplus machinery, unused vehicles, or redundant buildings).
• Advantages:
- Raises lump sums of cash: Can free up significant cash tied up in idle resources.
- No debt or interest charges: It does not require repayment or ongoing servicing costs.
- Improves efficiency: Disposing of unwanted assets cuts maintenance, storage, and insurance costs.
• Disadvantages:
- Finite resource: A business only has a limited number of surplus assets it can sell.
- Distress pricing: If cash is needed urgently, the business might have to accept a price well below fair market value.
- Potential operational constraint: Selling productive assets can reduce operating capacity.
C. Owners' Own Capital / Personal Savings
Common in sole traders and partnerships, this involves the entrepreneur investing their own personal savings directly into the firm.
• Advantages:
- Readily accessible with no lengthy application processes or credit checks.
- No interest charges or scheduled repayments.
- Demonstrates commitment, which may reassure future external lenders.
• Disadvantages:
- Often limited in amount depending on the entrepreneur's personal wealth.
- High personal financial risk if the business fails.
Key Takeaway: Internal sources carry no interest obligations and avoid loss of ownership, but their total value is strictly constrained by what the business already holds.
---3. External Sources of Finance
When internal funds fall short, firms look outside. External sources split broadly into debt finance (borrowed money that must be repaid, usually with interest) and equity finance (selling ownership stakes).
A. Bank Overdraft (Short-Term Debt)
An agreement with a commercial bank allowing the business to withdraw more money than is currently held in its bank account, up to an agreed limit.
• Advantages:
- High flexibility: The business uses only what it needs, when it needs it.
- Interest charged only on the borrowed balance: If the account returns to a positive balance, interest charges stop immediately.
- Speed: Quick to arrange and ideal for smoothing seasonal cash flow dips.
• Disadvantages:
- High interest rates: Daily interest rates on overdrafts are significantly higher than regular loan rates.
- Repayable on demand: Banks technically reserve the right to recall an overdraft with short notice.
- Not suitable for large, long-term purchases: Using it to buy machinery can quickly create financial distress.
B. Trade Credit (Short-Term Debt)
An arrangement where suppliers allow the business to receive raw materials or inventory immediately and pay for them at a later agreed date (typically 30, 60, or 90 days later).
• Advantages:
- Interest-free working capital: As long as invoices are paid on time, it costs nothing extra.
- Self-funding cycle: The business can often sell the inventory to customers before having to settle the bill with the supplier.
• Disadvantages:
- Loss of prompt-payment discounts: Suppliers frequently offer price discounts to firms that pay in cash immediately.
- Supplier relationship risk: Late payment damages goodwill, harms credit ratings, and can lead to suppliers refusing future orders.
C. Bank Loans (Medium- to Long-Term Debt)
A fixed sum of money borrowed from a commercial bank, repaid over an agreed period in scheduled instalments along with interest.
• Advantages:
- Retain total control: The bank gets interest repayments, but acquires no voting rights or ownership in the business.
- Predictable budgeting: Fixed repayment schedules make cash flow planning easier.
- Lower interest rates: Usually much cheaper per dollar borrowed than a bank overdraft.
• Disadvantages:
- Mandatory interest payments: Interest and capital repayments must be met regardless of whether the business makes a profit or a loss.
- Security/Collateral required: Banks often require collateral (pledging assets such as property that the bank can seize if the loan defaults).
- Application process: Requires a detailed business plan, credit vetting, and time to negotiate.
D. Mortgages (Long-Term Debt)
A specialised long-term loan (often 15 to 25 years) designed specifically to buy property or land, where the property itself acts as the collateral.
• Advantages: Structured over very long repayment periods with relatively low interest rates compared to unsecured borrowing.
• Disadvantages: The property can be repossessed by the lender if repayments are missed.
E. Leasing (Medium-Term)
A contract allowing a business to hire and use an asset (such as commercial vehicles, IT equipment, or plant machinery) for a specific monthly fee without owning it outright.
• Advantages:
- Protects cash balances: Avoids a large upfront capital outlay.
- Maintenance included: The leasing company is frequently responsible for maintenance and upgrades.
- Access to up-to-date technology: Assets can be updated easily at the end of the contract term.
• Disadvantages:
- Total cost: Over the full life of the agreement, total lease payments often exceed the original purchase price of the asset.
- No asset ownership: The asset cannot be sold by the business to raise cash because it belongs to the lessor.
F. Share Capital (Ordinary Shares) (Long-Term Equity)
Finance raised by selling shares (fractions of company ownership) to investors. In private limited companies, shares are sold privately to friends, family, or business associates; in public limited companies, shares are invited to the public on a stock exchange.
• Advantages:
- Permanent capital: Share capital does not need to be repaid to investors by the business.
- No mandatory interest charges: Dividends are only paid if the business makes a profit and the board of directors decides to distribute them.
- Substantial sums: Public share offerings can raise vast sums of money for major capital projects.
• Disadvantages:
- Dilution of ownership and control: Issuing new shares reduces the original owners' percentage holding and voting power.
- Risk of hostile takeover: For public companies, selling shares on the open market opens the door to outside takeover bids.
- Regulatory and administration costs: Issuing shares (especially publicly) is expensive, involving legal fees, underwriting costs, and strict reporting standards.
G. Venture Capital and Business Angels (Long-Term Equity)
Equity finance provided by wealthy individuals (business angels) or specialised investment firms (venture capitalists) to early-stage, high-growth, or high-risk businesses in exchange for an ownership stake and often a board seat.
• Advantages:
- Willing to back risky start-ups that commercial banks would turn down.
- Bring valuable expertise, strategic guidance, and industry networks.
• Disadvantages:
- Investors usually demand a significant percentage of equity and a say in major strategic decisions.
- They expect substantial returns and often focus on selling their stake within 3–7 years.
H. Government Grants
Financial awards made by governments or public development agencies to businesses to support specific regional development, employment creation, green technology, or innovation initiatives.
• Advantages: Non-repayable and interest-free, provided all conditions of the grant are met.
• Disadvantages: Highly competitive, accompanied by strict conditions, and involving extensive paperwork and monitoring.
4. Comparing Sources of Finance (Summary Matrix)
Use this comparison guide when revising advantages and disadvantages:
1. Retained Profit:
• Type / Term: Internal / Medium to Long-Term
• Cost: No interest (Opportunity cost)
• Impact on Control: None
• Key Drawback: Constrained by past profitability
2. Sale of Assets:
• Type / Term: Internal / Short to Long-Term
• Cost: No interest
• Impact on Control: None
• Key Drawback: Limited to existing surplus assets
3. Bank Overdraft:
• Type / Term: External Debt / Short-Term
• Cost: High variable interest on overdrawn balances
• Impact on Control: None
• Key Drawback: Repayable on demand; unsuitable for long-term investments
4. Trade Credit:
• Type / Term: External Debt / Short-Term
• Cost: Free if paid on time (Loss of discounts)
• Impact on Control: None
• Key Drawback: Damaged supplier relations if late
5. Bank Loan:
• Type / Term: External Debt / Medium to Long-Term
• Cost: Fixed or variable interest
• Impact on Control: None (Lenders have no votes)
• Key Drawback: Compulsory repayments regardless of performance; security needed
6. Leasing:
• Type / Term: External Facility / Medium-Term
• Cost: Ongoing regular rental payments
• Impact on Control: None
• Key Drawback: Long-term cost exceeds asset value; no asset ownership
7. Share Capital:
• Type / Term: External Equity / Long-Term (Permanent)
• Cost: Discretionary dividends
• Impact on Control: Dilutes ownership and voting power
• Key Drawback: Expensive to issue; potential loss of control
5. Factors Influencing the Choice of Finance (Evaluation / AO4)
In extended response exam questions (such as 16-mark and 24-mark questions in Unit 2), you are rarely asked just to list sources. You will be asked to evaluate the most appropriate source for a specific business context. Consider these core criteria:
1. Purpose and Time Horizon (Matching Principle)
• Buying raw materials to complete an order next week? Choose short-term finance (overdraft, trade credit).
• Buying a purpose-built logistics warehouse that will be used for 20 years? Choose long-term finance (mortgage, retained profit, share capital).
2. Legal Structure and Form of Business
• A sole trader cannot issue shares on a stock exchange; they must rely on personal capital, retained profit, bank loans, or trade credit.
• A public limited company has access to equity markets and can issue ordinary shares to raise millions of dollars.
3. Cost and Financial Risk
• Debt incurs interest that must be paid even if revenue collapses. Taking on excessive debt increases financial risk and gearing.
• Equity carries lower bankruptcy risk because dividends are discretionary, but it costs existing owners part of their ownership and future earnings.
4. Control
• If the current founders wish to protect 100% control, they will strongly avoid issuing shares to venture capitalists or outside investors, preferring loans or retained profit instead.
5. Amount Required
• A small cash shortfall of \$5,000 can be resolved with a short-term overdraft.
• An acquisition worth \$50,000,000 requires a coordinated mix of retained profit, long-term debt, and new share issues.
6. Common Exam Mistakes to Avoid
• Mistake 1: Confusing "retained profit" with "cash". A business can show a high accounting profit on paper while having very little actual cash available in its bank account because customers have bought on credit. Always check cash availability.
• Mistake 2: Stating that selling shares creates debt. Selling shares is equity finance. It never has to be repaid by the business and incurs no interest charges.
• Mistake 3: Suggesting an overdraft to buy premises or heavy machinery. Overdrafts are designed for short-term working capital swings. They carry high interest rates and can be recalled on demand, making them completely unsuitable for long-term assets.
• Mistake 4: Suggesting share issues for sole traders or partnerships. Sole traders and partnerships are unincorporated businesses and cannot issue shares.
7. Quick Review Check
Can you answer these questions without looking back?
1. What is the fundamental difference between debt finance and equity finance?
2. Why is retained profit often considered the most desirable source of finance?
3. Name two distinct risks of using a bank overdraft.
4. Why might an entrepreneur choose a bank loan over venture capital even if the loan charges 8% interest?
5. Which source of finance is best suited for upgrading a fleet of delivery vans every three years?
Answers:
1. Debt must be repaid with interest and creates no ownership change; equity gives away a share of ownership and profits, but requires no mandatory ongoing repayments.
2. It carries no interest charges, does not need to be repaid, and does not dilute existing ownership.
3. High interest rates compared to structured loans, and the risk that the bank can recall the overdraft on demand.
4. To retain complete ownership and control of the business without giving away equity or board representation.
5. Leasing (allows predictable payments, keeps technology up to date, and avoids large upfront capital costs).