Internal finance — Edexcel A-Level Business
Test yourself on Internal finance with PEARSON EDEXCEL A-Level practice questions.
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Internal finance explained
Money the owner puts in from personal savings is the cheapest finance a start up can get and the most dangerous to the person providing it.
Read the full explanation
There is no interest, no repayment schedule, no credit check and no outside shareholder to satisfy, so the founder keeps full control and the business carries no fixed charge in a month when sales disappoint. It counts as equity, so it lowers gearing, calculated as non current liabilities divided by capital employed and multiplied by one hundred to give a percentage, which in turn makes a bank more willing to lend alongside it. The costs are real. The sum available is limited to what one household has saved, the savings lose whatever interest or investment return they were earning, and for a sole trader with unlimited liability the family home is already exposed, so putting savings in concentrates every egg in one basket.
b) Retained profit
Profit kept in the business rather than paid out is the single largest source of finance for most established firms, and it is what remains after tax when dividends or drawings have been deducted. It costs no interest, needs no security and dilutes nobody's shareholding, so it is usually the first place a board looks. Three things limit it. A start up or a loss making firm has none. Retained profit is an accumulated figure in the statement of financial position, not cash, so a firm can be profitable and still unable to pay for the machine. And every pound retained is a pound not paid to shareholders, who may sell the shares or vote against the board, which is the classic short term against long term trade-off. A supermarket funding a refit from trading profit avoids gearing up, but shareholders notice a frozen dividend at once.
c) Sale of assets
Selling something the business owns turns an unproductive item on the statement of financial position back into cash, without borrowing and without giving away equity. It works best where the asset is genuinely surplus, an idle warehouse, obsolete machinery, spare land or a brand the firm no longer builds. A variation is sale and leaseback, where a retailer sells its stores to a property investor and rents them back, releasing a large sum at once and accepting a rental bill for the next twenty five years. The trade-offs are sharp. The cash arrives once and cannot be repeated, an asset sold below its book value records a loss on disposal in the income statement, and selling capacity a firm later needs pushes capacity utilisation towards a ceiling and forces expensive outsourcing. Buyers also sense urgency and bid accordingly.
Your focus
- a) Owner’s capital: personal savings
- b) Retained profit
- c) Sale of assets
Internal finance exam tips
Marking Points
- Explain that it carries no interest and no repayment date, so it protects cash flow in the fragile early months when revenue is unpredictable.
- Link it to control and ownership, since no equity is sold and no lender imposes covenants, which matters when the founder's objective is independence.
- Recognise the opportunity cost of the savings and the personal risk, especially where the business is a sole trader or partnership with unlimited liability.
- Judge its suitability against the amount needed, since personal savings typically cover a small start up but not a factory, and say what the firm should use alongside it.
- State that it is profit after tax and after dividends or drawings, and that it is reinvested rather than distributed.
- Explain the advantages precisely, no interest charge, no loss of control, no security required and no covenants, and link them to the named firm's circumstances.
- Show awareness that retained profit is not the same as cash in the bank, so a profitable firm with money tied up in inventory or receivables may still need an overdraft.
- Weigh the cost to shareholders of a lower dividend against the return the reinvestment is expected to earn, and reach a judgement about the time horizon.
- Explain that it converts a non current asset into cash without interest, repayment or any dilution of ownership.
- Distinguish selling a genuinely surplus asset from selling productive capacity, and say which the named business is doing.
- Recognise the consequences of sale and leaseback, an immediate cash inflow set against a long term rental commitment that raises fixed costs.
- Judge its suitability given the urgency of the need and the speed of sale, since property can take months while a distressed seller accepts a low price.
Examiner Tips
- 💡Questions usually ask you to assess the most appropriate source for a named business, so always compare it with at least one external option rather than praising it alone.
- 💡Tie the recommendation to the amount, the time period and the owner's attitude to risk and control, because that is where the evaluation marks sit.
- 💡If the extract gives a gearing figure or a bank's lending conditions, use it to show why the owner's own money makes borrowing easier.
- 💡Expect it in a comparison question against loans or share capital, where the marks come from matching the source to the size, the urgency and the gearing position.
- 💡If an income statement or a statement of financial position is provided, quote the profit for the year and the dividend to show how much is genuinely available.
- 💡A strong evaluation notes that using retained profit avoids raising gearing, which keeps borrowing capacity in reserve for a future opportunity.
- 💡It surfaces in cash flow crisis questions, where the examiner wants you to compare a quick internal fix with an overdraft or a loan on cost and on speed.
- 💡Use any figures given for the asset's value, and say plainly whether the sum raised is enough to close the gap shown in the cash flow forecast.
- 💡Mention the effect on capacity utilisation or on the ability to meet future demand; that consequence is where analysis becomes evaluation.
Common Mistakes
- Calling it free finance, which ignores the interest or investment return the savings would have earned and the risk the owner is taking on.
- Confusing owner's capital with retained profit; the first comes from the owner's own pocket, the second from trading the business has already done.
- Assuming there is no limit on it, so an answer recommends personal savings to fund an expansion far larger than any household could finance.
- Treating retained profit as a pile of cash sitting ready to spend, when it may already be invested in assets or absorbed by working capital.
- Forgetting that a new business has no trading history and therefore no retained profit, so recommending it to a start up is not an option at all.
- Ignoring the shareholders entirely, so the answer never mentions dividend expectations or the effect on the share price.
- Assuming the asset sells for its book value, when a forced sale often realises much less and produces a loss on disposal.
- Ignoring the lost use of the asset, so the answer recommends selling machinery that the firm needs to meet the very order it is trying to finance.
- Describing it as a long term solution when it is a one off inflow that cannot fund recurring costs such as wages.