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Businesses need finance in order to…
get started, allow them to grown and fund their continuing activity
Finance may be needed for capital…
expenditure (spending on fixed assets such as equipment, buildings, IT equipment and vehicles)
Finance is also required for revenue…
expenditure (spending on raw materials or day to day expenses such as wages or utilities
Businesses have different sources of finance available to them
When the finance comes from inside the business - internal source of finance
When the finance comes from outside the business - external source of finance
Internal finance comes from the…
owner’s capital, retained profit, or the sale of assets
Owners capital: personal savings (internal sources)
Are a key source of funds when a business starts up; owners may introduce their savings or another lump sum e.g. inheritance money. Owners may invest more as the business grows or if there is a specific need e.g. a short term cash flow problem
Retained profit (internal sources)
The money a business keeps from its profits after paying expenses, taxes, and dividends to shareholders. It's saved in the business to help it grow or cover future costs. This is a cheap source of finance as it doesn’t involve borrowing.
Sales of assets (internal sources)
Selling business assets (resources owned by a business) which are no longer required (e.g. land, buildings) generates a source of finance. The business sells an asset (most likely a building) for which it receives cash then rents the premises from the new owners.
Advantages of internal finance
internal finance is often free (e.g. doesn’t involve the payment of interest or charges)
doesn’t involve third parties who may influence business decisions
internal finance can usually be organised very quickly and without a lot of paperwork
Businesses that may fail credit checks (necessary for a bank loan) can access internal finance sources more easily
Disadvantages of internal finance
a significant opportunity cost involved in the use of internal finance (e.g. one retained profit has been used, it can’t be used for other purposes)
internal finance may not be sufficient to meet the needs of the business
using an internal finance method is rarely as tax-efficient as many external methods, e.g. load repayments may be treated as a business cost and offset against tax bills
External finance is sourced…
from outside of the business, two of the most common forms of finance include bank loans and share capital; Share capital for Ltd - usually sourced by selling shares to family and friends, or private venture capitalists AND share capital for plc - usually sourced by listing share on an initial public offering and selling them to investors through a stock exchange
Bank loans (external source of finance)
a sum of money borrowed from the bank and repaid (with interest) over a specific period of time
Pros - usually unsecured (no asset or collateral is required in order to gain access to the loan) and are typically repaid over 2-10 yrs AND interest rates are fixed for the term of the loan so repayments are made in equal instalments, which helps with business planning
Cons - interest is payable and the business assets are at risk if the business does not make repayments as planned
Share capital (external source of finance)
finance raised from the sale of shares in a limited company
Pros - large amounts of money can be quickly raised from wealthy investors AND shareholders who buy a large amount of shares may also bring and share expertise which can be beneficial to the business
Cons - shareholders are the owners of shares and are entitled to a share of the company’s profit when dividends are declared AND shareholders usually have a vote at a company’s annual general meeting (AGM) where they can have a say in the composition of the board of directors
