Sources of finance

Overview

Finance is the lifeblood of any business. Whether a start-up needs cash to buy its first batch of inventory or an established multinational wants to expand overseas, choosing the right source of finance is crucial. This topic covers the various ways businesses raise money, divided into internal sources (from within the business) and external sources (from outside).

Examiners consistently test this topic because it links directly to business strategy, risk, and cash flow. You will be expected not only to identify these sources but to evaluate their suitability for different contexts. A common pitfall is recommending a source of finance that a business in the given scenario could not realistically access (e.g., a start-up using retained profit). Understanding the trade-offs—such as losing control by issuing shares versus paying interest on a loan—is key to accessing the highest mark bands.

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Internal Sources of Finance

Internal sources are funds found inside the business. They are generally considered 'free' because they do not incur interest, but they have opportunity costs.

Retained Profit

What it is: Profit kept in the business after taxes and dividends have been paid.

Pros: No interest to pay; does not dilute ownership or control.

Cons: Once spent, it cannot be used elsewhere; not available to new start-ups or loss-making businesses.

Sale of Assets

What it is: Selling items the business owns (e.g., old machinery, vehicles, or buildings) to raise cash.

Pros: Quick way to raise cash without borrowing; clears out obsolete equipment.

Cons: The business loses the asset and its potential future use; can take time to find a buyer for large assets.

Owner's Capital

What it is: Personal savings put into the business by the entrepreneur.

Pros: Shows commitment to the business (which helps when asking banks for loans); no interest payments.

Cons: The owner risks losing their personal savings if the business fails.

External Sources of Finance

External sources involve bringing in money from outside the business. These often come with costs such as interest or a loss of control.

Bank Loan

What it is: A fixed amount of money borrowed from a bank, repaid in regular installments with interest over a set period.

Pros: Provides a guaranteed lump sum for major purchases; the business retains full ownership.

Cons: Interest must be paid regardless of profit; the bank usually requires collateral (security) which can be seized if the loan isn't repaid.

Overdraft

What it is: An agreement with the bank allowing a business to spend more money than it has in its account, up to an agreed limit.

Pros: Highly flexible for managing day-to-day cash flow shortages; interest is only paid on the amount borrowed.

Cons: Very high interest rates; the bank can demand repayment at any time.

Trade Credit

What it is: Buying goods or services from a supplier now and paying for them later (usually within 30, 60, or 90 days).

Pros: Helps cash flow as the business can sell the goods before having to pay the supplier.

Cons: Missing payment deadlines damages the relationship with the supplier and can result in losing credit facilities.

Share Issue

What it is: Raising capital by selling portions of ownership (shares) in a limited company to investors.

Pros: Can raise massive amounts of capital; the money does not need to be repaid, and no interest is charged.

Cons: Original owners lose a percentage of control; shareholders expect a share of profits (dividends).

Crowdfunding

What it is: Raising small amounts of money from a large number of people, typically via online platforms.

Pros: Good for start-ups; acts as market research to prove demand; no interest payments.

Cons: Can be time-consuming; if the target amount isn't reached, the money is often returned to investors.

The Role of the Finance Function

The finance department is responsible for keeping track of the money flowing in and out of the business. Their key roles include:

1. Providing Financial Information: Creating cash flow forecasts, income statements, and balance sheets.
2. Supporting Decision Making: Advising managers on whether they can afford to expand, hire new staff, or launch a marketing campaign.
3. Managing Cash Flow: Ensuring the business always has enough liquid cash to pay its bills on time.