Sources of finance

Welcome to the World of Finance!

Ever wondered how a small startup grows into a global giant? Or how your local café managed to buy that expensive new espresso machine? It all comes down to Sources of Finance. In this chapter, we are going to explore where businesses get the money they need to start, run, and grow. Knowing which "pot of money" to dip into is one of the most important decisions a business owner will ever make!

1. Internal Sources of Finance

Internal finance is money that comes from inside the business itself. Think of this like using your own pocket money or selling your old video games to buy something new. It doesn't involve borrowing from strangers.

Owners’ Investment

This is money put into the business by the people who own it. For a sole trader, this might be their life savings.
Example: Sarah uses £5,000 of her own savings to open a florist shop.

Retained Profit

This is profit that the business has made in the past but has kept (retained) rather than giving it to the owners. It is often called "ploughing back the profits."
Quick Tip: This is often considered the "best" source because there is no interest to pay and the business doesn't go into debt!

Sale of Assets

Businesses can raise cash by selling things they no longer need, like old machinery, delivery vans, or buildings.
Analogy: It’s like having a garage sale to raise money for a holiday. You get cash quickly, but you no longer have the items you sold!

Key Takeaway:

Internal finance is generally lower risk because you aren't borrowing from outsiders, but it is limited by how much the business actually owns or has saved.

2. External Sources of Finance

Sometimes, a business needs more money than it has inside. This is when they look externally (outside). This is like taking out a student loan or a mortgage.

Long-Term External Finance

Share Capital: Selling "shares" (parts of the ownership) of the company to investors. This is only for limited companies.
Venture Capital: Money from professional investors who look for high-growth businesses. They usually want a say in how the business is run in exchange for their big investment.
Loans: Borrowing a fixed amount of money for a set time (e.g., 5 years) and paying it back with interest.
Grants: "Free" money, usually from the government or charities, to help businesses in specific areas or industries. You usually don't have to pay these back, but they have strict rules!

Short-Term & Flexible External Finance

Bank Overdrafts: Allowing the business to spend more money than is in its bank account. This is great for emergencies but has high interest rates.
Leasing: Like "renting" equipment. You get to use the van or computer, but you never actually own it.
Trade Credit: Buying supplies now but paying for them later (usually 30–90 days).
Example: A baker gets flour today but doesn't have to pay the supplier until next month.
Credit Cards: Used for small, daily business expenses. Useful for flexibility but very expensive if not paid off quickly.
Crowdfunding: Raising small amounts of money from a large number of people, usually via the internet.

Key Takeaway:

External finance allows for rapid growth, but it often comes with a "price tag" (interest) or means the owners have to give up some control.

3. Factors Affecting the Choice of Finance

Don't worry if this seems like a lot of options! Managers use a "checklist" to decide which source is best for them. Here are the factors they consider:

• Cost: How much interest or dividends will we have to pay? (Loans = Interest; Shares = Dividends).
• Amount Required: You wouldn't sell shares just to buy a new printer! Small amounts use overdrafts; large amounts use loans or shares.
• Flexibility: Can we pay it back early? Can we get more money quickly if we need it?
• Retaining Control: Selling shares means new people get to vote on how the business is run. If owners want 100% control, they avoid share capital.
• The Use: Match the source to the "life" of the asset. Use a long-term loan for a new factory, but trade credit for stock.
• Timescale: How long do we need the money for? (Short-term vs. Long-term).
• Existing Debt: If a business already owes a lot of money, banks might be scared to lend them more.
• Business Structure: A Sole Trader cannot sell shares on the stock market; only Public Limited Companies (PLCs) can do that!

Memory Aid: "C-A-T-S"

When answering exam questions about choosing finance, think of C-A-T-S:
C - Cost (Interest?)
A - Amount (How much?)
T - Time (How long?)
S - Status/Structure (What type of business is it?)

4. Common Pitfalls & Quick Review

Common Mistake to Avoid: Many students think "Retained Profit" is the same as "Cash." It isn't! A business might have made a profit but already spent the cash on new stock. Always check if the business actually has the cash available.

Quick Review Box:

1. Which source of finance has no interest and no loss of control?
Answer: Retained Profit.
2. Which source is best for a startup with high risk but high potential?
Answer: Venture Capital.
3. What is the main disadvantage of a Bank Overdraft?
Answer: High interest rates and it can be withdrawn by the bank at any time.

Summary Takeaways

Internal Finance: Safe, cheap, but limited. Includes owners' savings and retained profits.
External Finance: Good for big projects, but involves interest or giving up control. Includes loans, shares, and leasing.
Suitability: There is no "perfect" source. The best choice depends on the cost, amount, control, and the legal structure of the business.

You've got this! Finance can be tricky, but once you understand that it's just about matching the right "pot of money" to the right "need," it all starts to click.