Sources of finance

Introduction: Where Does the Money Come From?

Welcome to one of the most practical chapters in your Business studies! Every business, from a small lemonade stand to a giant like Apple, needs money to survive and grow. This money is called finance. In this guide, we will explore the different "taps" a business can turn on to get the cash it needs. Don't worry if the options seem overwhelming at first—we'll break them down into simple categories so you can easily decide which "tap" is best for any business situation.

1. Internal vs. External Sources

The first way to categorize money is by looking at where it starts. Is it already inside the business, or do we have to go out and find it?

Internal Sources of Finance

These are funds found inside the business. Think of this like checking your own pockets or selling your old video games to buy a new one.

• Retained Profit: This is profit kept by the business from previous years rather than being paid out to owners. It is the most important source of long-term finance.
• Sale of Assets: Selling things the business owns but no longer needs, such as old machinery or an unused warehouse.
• Rationalisation: This involves making the business more efficient to free up cash, such as reducing the amount of inventory (stock) held in a warehouse.

External Sources of Finance

These are funds obtained from outside the business. This is like asking a bank for a loan or finding a partner to invest in your idea.

• Share Capital: Selling a "piece" of the business to investors in exchange for money. This is only available to private and public limited companies.
• Bank Loans: Borrowing a set amount of money for a specific purpose, paid back with interest over a set period.
• Overdrafts: A flexible arrangement where a bank allows a business to spend more money than it actually has in its account (up to a limit).
• Trade Credit: Buying raw materials now but paying the supplier 30, 60, or 90 days later.
• Venture Capital: Professional investors who provide large sums of money to small, high-growth businesses in exchange for a share of the business.
• Leasing: Paying a monthly fee to use an asset (like a car or a printer) instead of buying it outright.

Quick Review: Internal finance is "cheaper" because you don't pay interest, but it is limited to what you already have. External finance can provide huge amounts of money but often comes with "strings attached" like interest or giving up control.

2. Short-term vs. Long-term Finance

Businesses also choose finance based on how quickly they need to pay it back. This is often called the time horizon.

Short-term Finance (Usually repaid within 1 year)

Used for day-to-day expenses like paying wages or electricity bills.
Example: Using a bank overdraft to pay staff while waiting for a big customer to pay their invoice.

Long-term Finance (Repaid over many years or never)

Used for big "one-off" purchases like building a new factory or buying a fleet of trucks.
Example: Issuing share capital to fund an international expansion.

Memory Aid: Think of the Matching Principle. Use short-term money for short-term needs (like snacks) and long-term money for long-term needs (like a house!).

3. Factors Affecting the Choice of Finance

Choosing the right source of finance is a key management decision. Managers must look at several factors before signing a contract.

Time

How long do we need the money for? You wouldn't take out a 25-year loan to buy a box of pens! The time period of the finance should match the life of the asset being bought.

Legal Structure

A sole trader cannot sell shares on the stock market. Their options are limited to personal savings or bank loans. However, a Public Limited Company (PLC) has access to millions of potential investors through share capital.

Quantitative Factors (The Numbers)

• Cost: How much interest will the bank charge? Interest is the "price" of borrowing.
• Amount Needed: If you need £5 million, an overdraft won't be enough; you'll likely need a loan or share issue.

Qualitative Factors (The "Feel")

• Control: If you sell shares, you are giving away a piece of your "voting power." Many owners prefer a bank loan because the bank doesn't get to tell them how to run the business.
• Risk: If you can't pay back a bank loan, the bank might take your assets. Retained profit is the safest option because it doesn't have to be paid back.

External Influences

The economy plays a big role. If interest rates in the UK are very high, businesses will avoid bank loans because they are too expensive. If the economy is in a recession, venture capitalists might be too scared to invest in new ideas.

Key Takeaway: There is no "perfect" source of finance. The "best" choice depends on the specific needs of the business at that exact moment.

4. Impact on Stakeholders

When a business chooses a source of finance, it doesn't just affect the bank balance; it affects people!

• Shareholders: If the business issues more shares, the current shareholders' "slice of the pie" gets smaller (this is called dilution).
• Employees: Using retained profit to buy a machine might mean there is less money for staff bonuses this year.
• Lenders (Banks): They want to see that the business isn't "over-geared" (meaning it has too much debt compared to its own money).

Common Mistakes to Avoid

Mistake 1: Thinking that Share Capital is a loan. It isn't! The business doesn't have to pay the money back. Instead, investors hope to receive dividends (a share of the profits) and see the value of their shares go up.

Mistake 2: Using an Overdraft for long-term growth. Overdrafts have very high interest rates. It's an expensive way to borrow money for a long time.

Quick Review Box

Internal: Retained Profit, Sale of Assets.
External: Loans, Shares, Overdrafts, Trade Credit.
Short-term: Overdrafts, Trade Credit.
Long-term: Loans, Share Capital, Venture Capital.
Main Choice Factors: Time, Cost, Control, Legal Structure.