Why might a business choose a loan over issuing shares?

A business might choose a loan if it wants to retain full control, as loans do not dilute ownership. Loans also have a fixed repayment schedule, so the cost is predictable. However, loans must be repaid with interest, which increases financial risk. Issuing shares avoids repayment but gives shareholders a say in decisions and a share of profits.

What is trade credit and how does it work?

Trade credit is when a supplier allows a business to buy goods now and pay later, typically within 30-90 days. It is a short-term external source of finance that improves cash flow by delaying payment. However, if the business pays late, it may damage relationships or incur interest charges.

Can a sole trader use share capital as a source of finance?

No, a sole trader cannot issue shares because they are not a limited company. Sole traders can only use personal savings, loans, grants, or retained profit. To raise finance through shares, the business must be incorporated as a private limited company (Ltd) or public limited company (PLC).

What is the advantage of using retained profit?

Retained profit is an internal source that does not require repayment or interest, so it is cheap and low-risk. It also does not dilute ownership. However, it may not be available if the business has not made enough profit, and using it reduces the funds available for dividends or other investments.

How do I decide which source of finance is best for a business?

Consider the purpose (short-term vs long-term), amount needed, cost (interest, fees), risk (repayment ability), and business structure. For example, a startup needing £10,000 for equipment might use a loan or owner's capital, while a PLC needing £10 million for expansion might issue shares. Always weigh pros and cons based on the scenario.

Sources of finance

Q: What is the difference between internal and external sources of finance?

Internal sources come from within the business, such as retained profit, sale of assets, or owner's capital. They do not involve external parties and are often cheaper but limited. External sources come from outside, like bank loans, share capital, or trade credit. They can provide larger amounts but may involve interest, fees, or loss of control.

AQA

GCSE

This topic covers the various internal and external methods businesses use to raise the capital necessary for their operations and growth, requiring students to evaluate the suitability of these sources for different business types and situations.

Objectives

Exam Tips

Pitfalls

Key Terms

Mark Points

Topic Overview

Sources of finance are the various ways a business can obtain money to start up, expand, or manage its day-to-day operations. In the AQA GCSE Business course, you need to understand the difference between internal and external sources, as well as short-term and long-term options. This topic is crucial because choosing the right source of finance can affect a business's costs, control, and risk.

Internal sources include retained profit, sale of assets, and owner's capital. External sources include bank loans, overdrafts, trade credit, hire purchase, leasing, share capital, and venture capital. Each source has advantages and disadvantages depending on the business's size, purpose, and financial situation. For example, a startup might rely on owner's capital or a loan, while a large PLC might issue shares.

This topic links to other areas like cash flow, profit, and business ownership. Understanding sources of finance helps you analyse how businesses fund their activities and make strategic decisions. In exams, you'll often be asked to recommend a suitable source for a given scenario, so you need to justify your choice with clear reasons.

Key Concepts

Core ideas you must understand for this topic

→Internal vs external finance: Internal comes from within the business (e.g., retained profit), while external comes from outside (e.g., bank loans).
→Short-term vs long-term: Short-term (e.g., overdraft) is for day-to-day needs; long-term (e.g., shares) is for major investments.
→Risk and reward: Debt finance (loans) requires repayment with interest, increasing risk; equity finance (shares) dilutes control but doesn't need repayment.
→Factors affecting choice: Purpose, amount needed, time period, cost, and business ownership structure.
→Impact on financial statements: Loans increase liabilities; share capital increases equity; retained profit reduces retained earnings.

What You Need to Demonstrate

Key skills and knowledge for this topic

Identification of internal sources of finance (e.g., retained profit, selling assets)
Identification of external sources of finance (e.g., family and friends, loans, mortgages, share issues, overdrafts, trade credit, hire purchase, government grants)
Analysis of the advantages and disadvantages of specific sources of finance
Evaluation of the suitability of different sources of finance for new start-ups versus established businesses

Marking Points

Key points examiners look for in your answers

Identification of internal sources of finance (e.g., retained profit, selling assets)
Identification of external sources of finance (e.g., family and friends, loans, mortgages, share issues, overdrafts, trade credit, hire purchase, government grants)
Analysis of the advantages and disadvantages of specific sources of finance
Evaluation of the suitability of different sources of finance for new start-ups versus established businesses

Examiner Tips

Expert advice for maximising your marks

💡Always consider the size and age of the business when evaluating a source of finance
💡Use the context provided in the case study to justify why one source is more appropriate than another
💡Remember that 'retained profit' is only available to businesses that have already been trading profitably
💡Always justify your recommendation: In 'evaluate' questions, don't just list sources. Explain why a source is suitable (e.g., 'A loan is appropriate because the business needs a large amount for a long-term asset and can afford fixed repayments').
💡Use the context: If the scenario mentions a sole trader, they cannot issue shares. If it's a startup with no track record, a bank loan may be hard to get. Tailor your answer to the business type and situation.
💡Show awareness of drawbacks: High-scoring answers consider both advantages and disadvantages. For example, 'While a loan provides immediate funds, it increases gearing and interest costs, which could harm profitability if sales fall.'

Common Mistakes

Pitfalls to avoid in your exam answers

Confusing internal and external sources of finance
Failing to link the choice of finance to the specific needs or context of the business (e.g., suggesting a long-term loan for short-term cash flow issues)
Ignoring the cost of finance (e.g., interest payments or loss of ownership/control)
Misconception: 'A bank loan is always the best source of finance.' Correction: Loans require regular repayments and interest, which can strain cash flow. For a startup with no revenue, owner's capital or a grant might be better.
Misconception: 'Retained profit is free money.' Correction: Retained profit is profit kept in the business after dividends, but it still represents money that could have been paid to owners. Using it means less cash for other uses.
Misconception: 'Issuing shares is only for large companies.' Correction: While PLCs issue shares on stock exchanges, private limited companies (Ltd) can also issue shares to friends and family, though they are not traded publicly.

Frequently Asked Questions

Common questions students ask about this topic

Before You Start

Prior knowledge that will help with this topic

•Business ownership structures (sole trader, partnership, private limited company, public limited company) – because the ability to raise finance depends on legal structure.
•Profit and loss accounts – to understand retained profit and how it is calculated.
•Cash flow forecasting – to see why businesses need finance to cover short-term gaps.

Study Guide Available

Comprehensive revision notes & examples

Read Study Guide

Key Terminology

Essential terms to know

Likely Command Words

How questions on this topic are typically asked

Identify

Explain

Analyse

Evaluate

Ready to test yourself?

Practice questions tailored to this topic

Sources of finance

Topic Overview

Key Concepts

What You Need to Demonstrate

Marking Points

Examiner Tips

Common Mistakes

Frequently Asked Questions

Before You Start

Study Guide Available

Key Terminology

Likely Command Words

Ready to test yourself?

Related Topics in AQA GCSE Business

Analysing the financial performance of a business

Business in the real world

Business location

Business operations

Topic Synopsis

Key Concepts & Core Principles

Exam Tips & Revision Strategies

Common Misconceptions & Mistakes to Avoid

Examiner Marking Points

Sources of finance

Topic Overview

Key Concepts

What You Need to Demonstrate

Marking Points

Examiner Tips

Common Mistakes

Frequently Asked Questions

What is the difference between internal and external sources of finance?

Why might a business choose a loan over issuing shares?

What is trade credit and how does it work?

Can a sole trader use share capital as a source of finance?

What is the advantage of using retained profit?

How do I decide which source of finance is best for a business?

Before You Start

Study Guide Available

Key Terminology

Gearing

Venture Capital

Retained Profit

Crowdfunding

Sale and Leaseback

Likely Command Words

Ready to test yourself?

Related Topics in AQA GCSE Business

Analysing the financial performance of a business

Business in the real world

Business location

Business operations