Sources of finance

Introduction: Where Does the Money Come From?

Welcome to one of the most important chapters in your Business studies! Think of finance as the "fuel" that keeps a business's engine running. Whether a business is just starting out, trying to survive a quiet month, or planning to take over the world, it needs money. In this chapter, we will explore the different places a business can get this money from and why they might choose one place over another.

Don't worry if the world of "finance" sounds a bit intimidating at first. By the end of these notes, you’ll see that choosing a source of finance is a lot like choosing how to pay for a new phone—do you use your savings, ask your parents for a loan, or pay in monthly installments? Let’s dive in!

1. Internal vs. External Sources of Finance

The first way we group money is by where it comes from: inside the business or outside the business.

Internal Sources of Finance

This is money that the business already has or generates itself. It’s like using your own pocket money to buy a snack.

• Retained Profit: This is the profit kept by the business after all costs and taxes are paid. It is the most important source of long-term finance.
Analogy: This is like a "piggy bank" where a business keeps its leftover lunch money to buy something bigger later.

• Sale of Assets: This involves selling things the business owns but no longer needs, such as old machinery, a delivery van, or an unused building.
Example: A bakery selling its old bread van because it now uses a delivery service.

External Sources of Finance

This is money that comes from people or organisations outside the business, like banks or investors. This usually comes with a "price," such as interest.

• Bank Loans: A set amount of money borrowed for a specific period, paid back with interest.
• Overdrafts: Allowing a business to spend more money than it actually has in its bank account (up to a limit).
• Share Capital: Only for companies (Private or Public Limited Companies). The business sells "shares" (pieces of ownership) to investors in exchange for money.
• Trade Credit: Buying supplies now and paying for them later (usually 30–90 days).
• Venture Capital: Professional investors who provide large sums of money to small, high-growth businesses in exchange for a share of the business.

Quick Review: Internal finance is "free" (no interest), but limited. External finance can provide huge amounts of money but often costs extra in interest or means giving up some control.

2. Short-term vs. Long-term Finance

Businesses also categorise money based on how long they need it for and how quickly they have to pay it back.

Short-term Finance (Needs to be repaid within 1 year)

Used for "day-to-day" expenses like paying electricity bills or buying stock.
• Overdrafts: Great for emergencies or when a customer is late paying their bill.
• Trade Credit: Helps with cash flow by letting the business sell the goods before they have to pay the supplier.

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

Used for "big" things like opening a new factory or buying expensive equipment.
• Bank Loans/Mortgages: Often used for buying property.
• Share Capital: This is "permanent" finance because the business doesn't usually pay it back; instead, they pay investors a share of the profits called dividends.

Memory Aid: The "Time" Rule
Match the length of the loan to the life of the asset. Use short-term finance for things that disappear quickly (like stock) and long-term finance for things that last a long time (like buildings).

3. Factors Affecting the Choice of Finance

Why doesn't every business just take a loan? Managers have to consider several factors before deciding.

A. Time

How quickly is the money needed? An overdraft can be set up almost instantly, but selling shares can take many months of legal paperwork.

B. Legal Structure

The "type" of business matters.
• A Sole Trader cannot sell shares; they are limited to personal savings or small bank loans.
• A Public Limited Company (PLC) can raise millions by selling shares on the stock market.

C. Quantitative Factors (The Numbers)

• Cost: What is the interest rate? High interest rates make loans expensive.
• Amount: You wouldn't sell shares just to buy a new laptop; you'd use a credit card or cash.

D. Qualitative Factors (The Feelings/Control)

• Control: If a business owner sells shares, they are giving away a piece of their "baby." Some owners prefer a bank loan because the bank doesn't get to tell them how to run the shop.
• Risk: If a business can't pay back a loan, they could lose their assets. Retained profit is much safer.

E. External Influences

• The Economy: If the economy is in a recession, banks might be "scared" to lend money.
• Interest Rates: If the central bank raises rates, borrowing money becomes more expensive for everyone.

Key Takeaway: There is no "perfect" source of finance. A business must balance the cost, the risk, and how much control they want to keep.

4. Impact on Stakeholders

Choosing a source of finance doesn't just affect the owner; it affects everyone involved with the business (stakeholders).

• Shareholders/Owners: They might see their dividends go down if the business has to pay lots of interest to a bank. However, if the finance is used to grow, their shares might become more valuable.
• Lenders (Banks): They want to make sure the business is safe enough to pay the money back. They will look at the business's gearing (how much debt they already have).
• Employees: If a business takes on too much debt and struggles to pay it back, employees might worry about their job security.

5. Common Mistakes to Avoid

Mistake 1: Confusing Profit with Cash.
Just because a business has Retained Profit on paper doesn't mean they have a pile of cash in the bank. The profit might already be tied up in stock or machinery. Always check the cash position!

Mistake 2: Thinking "Shares" are a loan.
Shares are equity. You don't pay them back like a loan, but you do give away ownership forever. It is a very big decision!

Quick Review Box: Summary of Sources
• Need cash for 2 weeks? Use an Overdraft.
• Need to buy a 30-year factory? Use a Mortgage or Share Capital.
• Want to keep 100% control? Use Retained Profit or a Loan (NOT shares).
• Buying a fleet of vans? Use a Bank Loan.

Did you know? Many famous companies like Apple and Microsoft started with "Bootstrap Finance"—which is just a fancy way of saying the owners used their own personal savings and credit cards because banks wouldn't lend to them yet!