Welcome to Sources of Finance!
Ever wondered how a small local bakery buys its first delivery van, or how a giant company like Apple builds a new headquarters? They need money! In Business, we call this "finance."
In this chapter, we are going to explore where businesses get their money from. Don't worry if it seems like a lot of terms at first—think of it like looking for "fuel" for a car. Some fuel comes from the tank (inside), and some comes from the petrol station (outside).
1. The Two Big Categories
Before we dive into the specific ways to get money, we need to split them into two groups:
- Internal Sources: Money found from inside the business itself.
- External Sources: Money brought in from outside individuals or organizations (like banks).
Quick Review: Internal = Inside. External = Outside. Simple as that!
2. Internal Sources of Finance
This is often the cheapest way to get money because you don't have to pay it back to a bank with extra "interest."
Retained Profit
This is profit that the business has kept from previous years instead of giving it to the owners. Analogy: Imagine you earned £20 for mowing the lawn. If you save £10 of that to buy a new lawnmower later, that is your "retained profit."
Advantages: No interest to pay; the business stays in full control.
Disadvantages: A new business might not have any profit yet; owners might want that money for themselves instead.
Selling Unwanted Assets
An asset is something the business owns, like machinery, land, or vehicles. If they don't need it anymore, they can sell it for cash. Example: A delivery company sells three old vans they no longer use to raise money for a new warehouse.
Advantages: Gets rid of junk and turns it into useful cash.
Disadvantages: You can only sell an asset once! If you sell it and then realize you need it, it’s too late.
Key Takeaway: Internal finance is low-risk because you aren't borrowing from anyone else.
3. External Sources of Finance
When the "piggy bank" is empty, businesses look outside.
Family and Friends
Common for new start-up businesses. The owner borrows money from people they know personally.
Advantages: Often zero or very low interest; flexible repayment.
Disadvantages: Can cause huge arguments and ruin relationships if the money can't be paid back!
Bank Loan
A set amount of money borrowed for a specific purpose, paid back in monthly installments over a set period (like 5 years) with interest added on.
Advantages: Good for big, long-term purchases; easy to plan your budget.
Disadvantages: You must pay it back even if you aren't making a profit; the bank might ask for "security" (like your house) if you can't pay.
Mortgage
A special type of long-term loan specifically for buying property or land (usually lasting 25 years).
Advantages: The only way most businesses can afford to buy their own building.
Disadvantages: If you stop paying, the bank can take the building away.
Overdraft
This allows a business to spend more money than they actually have in their bank account, up to a certain limit.
Memory Aid: Think of an overdraft as an "Emergency Buffer." It’s meant for short-term problems, like a quick dip in cash.
Advantages: Very flexible for daily expenses.
Disadvantages: Very high interest rates if used for a long time.
Trade Credit
This is "Buy Now, Pay Later" for businesses. Suppliers give the business the items they need (like raw materials), but allow them to pay 30, 60, or 90 days later.
Advantages: Helps the business sell the products before they have to pay for the materials.
Disadvantages: If you pay late, the supplier might stop selling to you.
Hire Purchase
The business "rents" an item (like a car or machine) and pays in installments. Once the last payment is made, they own the item.
Advantages: You get to use expensive equipment immediately without paying the full price upfront.
Disadvantages: The equipment is more expensive in total because of interest.
New Share Issue
Selling a "piece" of the business to investors. This is only available to Limited Companies (Ltd or Plc).
Advantages: You never have to pay the money back!
Disadvantages: You lose some control of the business; you have to share your future profits with the new owners.
Government Grants
Money given to a business by the government, often to help create jobs in poor areas or for "green" projects.
Did you know? Grants are usually "free" money—you don't have to pay them back! However, you usually have to meet very strict rules to get one.
Key Takeaway: External finance often costs more (interest) and carries more risk, but it allows for much bigger growth.
4. Which Source is Best? (Suitability)
Choosing the right source is like choosing the right shoes—it depends on where you are going!
For a New Start-up Business:
They usually struggle to get bank loans because they have no "track record." They often rely on:
- Family and Friends
- Owners' personal savings
- Small Government Grants
For an Established Business:
They have a history of making money, so banks trust them more. They use:
- Retained Profit
- Bank Loans/Mortgages
- Issuing New Shares
Quick Review Box: Matching the Source to the Need
- Buying a building? Mortgage.
- Buying a few boxes of stock? Trade Credit.
- Buying a new delivery truck? Hire Purchase or Loan.
- Fixing a temporary cash shortage this week? Overdraft.
5. Common Mistakes to Avoid
- Confusing a Grant with a Loan: Remember, you pay back a loan with interest, but you usually don't pay back a grant.
- Thinking anyone can sell shares: Only Limited Companies (Private or Public) can sell shares. A Sole Trader cannot!
- Thinking Internal Finance is "Free": While there is no interest, there is an "opportunity cost." If you use your profit to buy a van, you can't use that same money to give yourself a pay rise!
Final Summary Takeaway
Internal sources (retained profit, selling assets) are safe but limited. External sources (loans, overdrafts, shares, trade credit) provide more money but often come with interest or a loss of control. The "best" source depends on the size of the business and what they are buying.