Introduction to Internal Finance
Welcome to your study notes on Internal Finance! This chapter is part of the "Raising Finance" section of your course. Before a business looks at borrowing money from a bank or finding investors, it often looks "inside" itself first. Internal finance is simply money that comes from within the business or from the people who own it. It’s a great place to start because it’s often the cheapest and quickest way to get things moving. Don't worry if finance sounds a bit dry; we'll break it down into simple, real-life ideas!
What is Internal Finance?
Think of internal finance like using your own savings to buy a new phone rather than asking your parents for a loan or using a credit card. It’s money the business already "owns" or has access to without going to an outside source like a bank.
Quick Review: Why use internal finance?
1. No interest to pay back.
2. No lengthy bank meetings or paperwork.
3. You keep full control of the business.
According to your syllabus, there are three main types of internal finance you need to know: Owner's Capital, Retained Profit, and Sale of Assets.
Memory Aid: Just remember "O.R.S."
O - Owner's Capital
R - Retained Profit
S - Sale of Assets
1. Owner’s Capital: Personal Savings
This is money that the owner puts into the business from their own personal savings. This is the most common way for small businesses and start-ups to get the cash they need to open their doors.
How it works:
If you decide to start a dog-grooming business and you use £2,000 you saved up from a part-time job to buy clippers and a table, that is owner's capital.
Pros and Cons:
Pros:
- No interest: You don't have to pay yourself back with extra money on top.
- Shows commitment: If you do eventually go to a bank, they love to see that you’ve risked your own money first. It shows you believe in the business!
Cons:
- Risk: If the business fails, you lose your life savings. That can be very scary!
- Limited amounts: Most people don't have millions of pounds sitting in their bank account, so it might not be enough for big projects.
Key Takeaway: Owner's capital is the owner's own skin in the game. It’s fast and interest-free, but it’s limited by how much the owner actually has.
2. Retained Profit
Retained profit is the money left over after a business has paid all its costs, taxes, and paid any dividends (share of profit) to its owners/shareholders. Instead of spending that profit, the business keeps it to reinvest.
The Formula:
\( \text{Retained Profit} = \text{Total Profit} - \text{Tax} - \text{Dividends Paid to Shareholders} \)
The "Seeds" Analogy:
Think of a farmer. At the end of the year, they harvest their corn. They sell most of it to make a living, but they keep (retain) some of the best seeds to plant next year so the farm can grow. Retained profit is the "seeds" of the business world.
Pros and Cons:
Pros:
- It's "Free": It doesn't cost anything to use your own profit (no interest or fees).
- Flexibility: The business can choose exactly how to spend it without answering to a bank.
Cons:
- Unhappy Shareholders: If a business keeps all the profit to reinvest, the shareholders don't get their dividends. They might get grumpy!
- Not for Start-ups: New businesses haven't made any profit yet, so they can't use this method.
Did you know? Many massive companies, like Apple or Google, keep billions of dollars in retained profit so they can buy other companies or invent new gadgets whenever they want!
Key Takeaway: Retained profit is the most important source of long-term internal finance for established businesses.
3. Sale of Assets
An asset is something the business owns (like a van, a building, or a piece of machinery). Sale of assets involves selling these items to raise immediate cash.
How it works:
Imagine a bakery that has an old delivery van they no longer use because they now hire a courier. By selling that van for £5,000, they get a "cash injection" that they can use to buy a new industrial oven.
Two ways to do this:
1. Selling unwanted items: Selling things you don't need anymore (like the old van).
2. Sale and Leaseback: This is a bit more advanced! A business sells an asset they do need (like their office building) to a specialist company to get a huge pile of cash. They then immediately rent (lease) it back so they can keep using it. It’s like selling your laptop to a friend for £200 but paying them £5 a week to keep using it.
Pros and Cons:
Pros:
- Clears space: It gets rid of "dead wood" or things the business isn't using.
- No debt: You aren't borrowing; you’re just turning "stuff" into "cash."
Cons:
- One-time deal: Once you've sold the van, you can't sell it again!
- Urgency: If a business needs money fast, they might sell the asset for much less than it's actually worth.
Common Mistake to Avoid: Don't confuse selling assets with selling products. Selling bread is a bakery's daily job (Revenue). Selling the oven is a Sale of Asset (Finance).
Key Takeaway: Sale of assets is great for raising cash from things the business already owns, but it's not a sustainable way to fund a business forever.
Summary: Internal Finance Quick Look
Owner's Capital: Best for new start-ups. Personal risk is high.
Retained Profit: Best for successful, established businesses. No interest, but may upset shareholders.
Sale of Assets: Best for businesses with extra equipment or buildings. Provides a quick cash boost.
Final Encouragement:
You've just covered the basics of how businesses fund themselves from within! If these concepts feel a bit abstract, just keep thinking about the ORS mnemonic and the "Lemonade Stand" or "Pocket Money" analogies. You're doing great!