Sources of Finance (AQA A-Level Business): Revision Notes
Advantages and Disadvantages of Different Sources of Finance
Understanding the various sources of finance available to businesses is crucial for making informed financial decisions. Each source has its own benefits and drawbacks, and choosing the right one depends on factors like the time period needed, the cost involved, and the impact on business ownership and control.
Overview of sources of finance
Businesses can access finance from both internal and external sources, which can be used for either short-term or long-term purposes. The key is matching the right source to the specific financial need.
Internal sources come from within the business (like retained profit or sale of assets), while external sources come from outside (like loans, overdrafts, or new investors). Understanding this distinction helps businesses evaluate their options effectively.
Long-term sources
Long-term sources provide finance for extended periods, typically over one year.
Sale of assets occurs when a business sells items it no longer requires to raise funds. This might include machinery, warehouse space, factory buildings, or land. While this approach can generate significant amounts of capital, businesses must be confident they won't need these assets in the future.
Once assets are sold, they cannot be recovered. This makes the decision permanent and irreversible, so businesses must carefully evaluate their long-term needs before proceeding with asset sales.
Short-term sources
Short-term sources provide finance for periods typically under one year.
Overdraft is an arrangement where a bank permits a business to spend more money than it has in its account, up to an agreed maximum limit. This is highly flexible because the business only uses what it needs, and interest charges apply only to the overdrawn amount. Overdrafts are quick to arrange and ideal for managing temporary cash flow problems, though they can be expensive.
Debt factoring (also called invoice factoring) involves selling unpaid customer invoices to a bank or specialist financial institution. The business receives approximately 80% of the invoice value immediately, helping with cash flow. The remaining amount (minus charges) is paid once the factoring company collects payment from the customer. This releases cash tied up in unpaid bills and can reduce administration costs.
Debt factoring essentially converts future cash (unpaid invoices) into immediate cash, helping businesses that need money now but are waiting for customers to pay. The factoring company takes over the collection process, which can save time and administrative effort.
Trade credit allows a business to receive goods or materials from suppliers but delay payment until a later date. The credit period can range from a week to several months, helping businesses manage their cash flow by aligning payments with when they generate income from sales.
Comparing advantages and disadvantages
Each source of finance has specific benefits and limitations that businesses must carefully weigh when making funding decisions.
Retained profit
Retained profit refers to the earnings a business keeps after paying dividends to shareholders. This is money generated internally from successful trading.
Advantages:
- There is no interest cost, making it essentially free finance for the business
- The money doesn't need to be repaid to anyone, unlike loans or overdrafts
- Using retained profit avoids dilution of shares, meaning existing shareholders maintain their percentage ownership and control of the business
Disadvantages:
- Shareholders may receive reduced or no dividends, which could make them unhappy and potentially cause them to sell their shares
- The amount available depends entirely on how profitable the business has been
Dilution of shares occurs when new shares are issued, reducing the ownership percentage of existing shareholders. For example, if you own 100 shares out of 1,000 (10% ownership) and the company issues 500 new shares, you now own 100 out of 1,500 shares (only 6.67% ownership).
Sale of assets
Advantages:
- No interest charges are involved since this is not borrowed money
- The funds don't need to be repaid, providing permanent capital
- Share ownership remains unchanged, so there's no dilution of control
Disadvantages:
- Once assets are sold, they're gone forever - the business cannot recover them if circumstances change
- The business must be absolutely certain it won't need these assets in the future
- There may be costs involved in the sale process (legal fees, agent commissions)
Common Mistake to Avoid: Businesses sometimes sell assets in a crisis without fully considering future needs. Always ensure the assets are truly surplus to requirements and won't be needed when the business grows or market conditions change.
Equity
Equity finance means selling shares in the business to raise capital from investors.
Advantages:
- No interest payments are required, unlike debt finance
- The money raised doesn't need to be repaid, as shareholders buy permanent ownership stakes
- Risk is shared with new investors who become part-owners
Disadvantages:
- New shares might upset existing shareholders who see their ownership percentage decrease (dilution)
- Existing shareholders may also lose voting power and influence over business decisions
- New shareholders will expect dividends when the business is profitable
Worked Example: Understanding Equity Dilution
A founder owns 1,000 shares out of 1,000 total shares (100% ownership).
The business issues 500 new shares to raise capital from investors.
After the equity issue:
- Total shares = 1,000 + 500 = 1,500 shares
- Founder's ownership = 1,000 ÷ 1,500 = 66.67%
- New investors' ownership = 500 ÷ 1,500 = 33.33%
The founder's ownership has been diluted from 100% to 66.67%.
Loans
Loans are fixed amounts of money borrowed from banks or other lenders, repaid over an agreed period with interest.
Advantages:
- Ownership stays the same - there's no dilution of shares or loss of control
- Loan amounts and repayment schedules are predictable, helping with financial planning
Disadvantages:
- Regular interest payments must be made regardless of business performance, creating fixed costs
- The loan has a set maturity date when the full amount must be repaid
- Security or collateral may be required, putting business assets at risk if repayments cannot be met
Loans are often described as secured or unsecured. Secured loans require collateral (like property or equipment), which the lender can seize if repayments aren't made. Unsecured loans don't require collateral but typically have higher interest rates to compensate for the increased risk to the lender.
Overdraft
Advantages:
- Quick and easy to arrange with the bank - usually faster than applying for a loan
- Very flexible - businesses can use as much or as little as needed within the agreed limit
- Interest is charged only on the actual amount overdrawn, not the full overdraft limit
Disadvantages:
- Interest rates are typically higher than standard business loans
- Banks can demand repayment at short notice or withdraw the facility
- It's designed for short-term use, not as a permanent source of finance
Critical Point: Overdrafts are repayable on demand, meaning the bank can ask for the money back at any time. This makes them unsuitable for long-term finance needs or purchasing fixed assets. Always use overdrafts only for temporary cash flow management.
Debt factoring
Advantages:
- Provides immediate cash - usually 80% of invoice value straight away
- Improves cash flow by releasing money tied up in unpaid customer invoices
- Offers protection from bad debts since the factoring company often takes on the collection risk
- Reduces administration costs because the factoring company handles invoice collection
Disadvantages:
- This is an expensive option with various fees and charges
- Customer relationships may be affected if the factoring company pursues payment aggressively
- Customers may view it negatively, perceiving the business has cash flow problems
Bad debts occur when customers fail to pay their invoices, resulting in a loss for the business. Many factoring companies offer protection against this by assuming the risk themselves. If a customer doesn't pay, the factoring company (not your business) takes the loss - though this service typically costs extra.
Trade credit
Advantages:
- Eases cash flow pressure by delaying payment for supplies
- Acts as a free source of short-term finance if no interest is charged
- Allows businesses to sell goods before paying suppliers, improving working capital
Disadvantages:
- Late payment can seriously damage the business's credit history and credit rating
- Suppliers may withdraw credit facilities or refuse future orders
- Missing payment deadlines might result in penalty charges
Warning: Your credit rating affects your ability to borrow money in the future. Late payments to suppliers are recorded by credit reference agencies and can make it difficult or more expensive to access finance later. Always prioritize making payments on time, even if cash flow is tight.
How Trade Credit Works in Practice:
A business orders $10,000 worth of inventory with 30-day trade credit terms. The goods arrive immediately, but payment isn't due for 30 days. During this period, the business can sell the inventory and generate cash before the supplier payment is due. This effectively provides free short-term finance for the business's operations.
Exam tips
Key Considerations for Exam Questions:
When answering questions about sources of finance, always consider:
- Time period - is the finance needed for short-term or long-term purposes?
- Cost - does the source involve interest payments or other charges?
- Control - does the source affect ownership or require giving up shares?
- Business position - does it have sufficient profit, assets, or creditworthiness?
- Real examples - use UK business examples where possible to illustrate your points
Match your answer to the specific context given in the question. A startup business will have different options compared to an established profitable company.
Remember!
Key Points to Remember:
- Retained profit and equity both avoid interest costs, but equity dilutes ownership while retained profit may reduce shareholder dividends
- Overdrafts are flexible but expensive - ideal for short-term cash flow gaps but with higher interest rates than loans
- Debt factoring provides immediate cash from unpaid invoices but is costly and may affect customer relationships
- Trade credit is effectively free short-term finance, but late payment damages creditworthiness
- Sale of assets is permanent - once sold, assets cannot be recovered, so businesses must be certain they're surplus to requirements
- Time period matters - match short-term sources to short-term needs and long-term sources to long-term needs
- Control vs cost trade-off - debt finance (loans, overdrafts) maintains control but costs interest; equity finance avoids interest but dilutes ownership