Welcome to Internal Finance!
In this chapter, we are exploring the first part of Raising Finance. Before a business goes to a bank or asks a stranger for money, they usually look inside the business first. This is what we call Internal Finance. Think of it like checking your own pockets and piggy bank for spare change before asking your parents for a loan!
Learning this is important because choosing the right source of finance can be the difference between a business thriving or failing. Let’s dive in!
What is Internal Finance?
Internal finance is money that comes from within the business itself. The business doesn't have to pay it back to a bank, and they don't have to pay interest on it. It’s their own money.
According to your Pearson Edexcel syllabus, there are three main types you need to know:
- Owner’s Capital (Personal Savings)
- Retained Profit
- Sale of Assets
Don't worry if these terms sound fancy; we are going to break them down right now!
1. Owner’s Capital: Personal Savings
This is simply the money that the owner of the business invests from their own personal savings. This is very common for new, small businesses (start-ups).
Why use it?
- No Interest: Since it's your money, you don't have to pay yourself back with interest.
- Full Control: You don't have to listen to a bank or an investor telling you how to run things.
- Shows Commitment: If you put your own money in, banks are more likely to trust you later because you are "putting your money where your mouth is."
The Downside
The biggest risk is that if the business fails, the owner loses their life savings. There is also a limit to how much one person usually has in their bank account!
Analogy: Imagine you want to start a dog-walking business. You use the £200 you saved up from your birthday to buy leashes and flyers. That is Owner's Capital.
Quick Takeaway: Owner's capital is the owner's own "skin in the game." It's cheap but limited.
2. Retained Profit
Retained profit is the money left over after a business has paid all its costs, taxes, and paid the owners (shareholders). Instead of spending that profit, the business "retains" (keeps) it to reinvest back into the company.
For established businesses, this is often the most important source of finance.
Why use it?
- It’s "Free": There are no interest charges or administration fees.
- No Debt: You aren't borrowing, so you don't have the stress of monthly repayments.
- Flexibility: The business can choose exactly how to spend it without asking permission.
The Downside
- Shareholder Unhappiness: If a business is a company, the owners (shareholders) might be annoyed if the profit is kept in the business instead of being paid to them as dividends.
- Growth is Slow: You can only spend what you’ve already earned. If you want to build a giant factory, you might not have enough profit saved up yet.
Memory Aid: Think of Retained Profit as a Reward for Patience. You save your profits today to grow bigger tomorrow.
Quick Takeaway: This is the cheapest form of finance, but you have to actually make a profit first to use it!
3. Sale of Assets
An asset is something the business owns (like a van, a building, or a piece of machinery). Sale of assets happens when a business sells something it no longer needs to raise cash quickly.
Why use it?
- Quick Cash: Selling an unused warehouse can bring in a lot of money very quickly.
- Efficiency: It gets rid of "dead wood"—things the business is paying to maintain but doesn't actually use.
The Downside
- Once it's gone, it's gone: You can only sell an asset once. You can't rely on this as a permanent way to get money.
- Fire Sales: If a business is desperate for money, they might sell the asset for much less than it's actually worth.
Real-World Example: A delivery company decides to upgrade its fleet. They sell their 5-year-old vans to a local handyman. The money they get from those old vans is used to help buy the new ones. That is Sale of Assets.
Quick Takeaway: Selling assets is great for a quick "cash injection," but you can't do it forever!
Summary Table: Internal Finance
Here is a quick review of the three sources:
1. Owner’s Capital
Source: Personal bank account.
Best for: Start-ups.
Risk: High personal loss.
2. Retained Profit
Source: Business savings from previous years.
Best for: Established, profitable businesses.
Risk: May upset shareholders.
3. Sale of Assets
Source: Selling off equipment/buildings.
Best for: Quick cash or restructuring.
Risk: Loss of the asset's future use.
Common Mistakes to Avoid
- Mistake: Thinking internal finance is "unlimited."
Reality: Internal finance is strictly limited to what the business or owner already has. For massive expansion, external finance is usually needed. - Mistake: Thinking Retained Profit is the same as "Cash."
Reality: A business can be profitable but still have no cash in the bank (e.g., if customers haven't paid their bills yet). You can only use profit for finance if it’s available as cash. - Mistake: Forgetting about Opportunity Cost.
Reality: If you use your personal savings for the business, the "cost" is the interest you would have earned if you left it in a high-interest savings account.
Did you know?
Many of the world's biggest companies, like Apple and Google, hold billions of dollars in retained profits. They have so much internal finance that they rarely need to ask a bank for a loan!
Great job! You've finished the notes on Internal Finance. In the next section, we will look at External Finance—where businesses go when their own pockets aren't deep enough.