Internal and External Sources of Finance (AQA A-Level Business): Revision Notes
Internal and External Sources of Finance
Introduction to sources of finance
Every business needs money to operate, grow, and achieve its objectives. These funds can come from two main categories: internal sources (money generated from within the business) and external sources (money obtained from outside the business). Understanding the different options available helps businesses make informed decisions about which sources best suit their needs.
Internal sources of finance
Internal finance refers to money that a business generates from its own operations and assets. These sources don't require borrowing from external parties or bringing in new investors. The main internal sources are retained profit and sale of assets.
Internal sources of finance are particularly attractive because they don't create debt obligations or require giving up ownership stakes in the business. However, they're only available if the business has sufficient profits or assets to draw upon.
Retained profit
Retained profit is the portion of a company's profit that is not distributed to shareholders as dividends. Instead, this money stays within the business and can be used for future investment and growth.
This is often considered one of the most valuable sources of finance because it has several important benefits:
- There is no need to pay interest on this money
- The business doesn't have to repay it to anyone
- Using retained profit doesn't dilute existing shareholders' ownership
- It's available immediately without the need to apply for loans or seek investors
Key Limitation of Retained Profit
Businesses can only access this source if they are actually making a profit. Start-ups and loss-making businesses cannot use retained profit as a source of finance. Additionally, shareholders might be disappointed if they receive reduced dividends because the company is retaining more profit.
Sale of assets
Sometimes a business can raise funds by selling assets (items of value it owns) that are no longer needed. These might include:
- Machinery or equipment that's been replaced or isn't being used
- Vehicles that are surplus to requirements
- Buildings, warehouses, or land that the business no longer needs
- Factory space that has become unnecessary
This approach can raise significant amounts of money, particularly if the assets being sold are valuable property or land. The key advantage is that, like retained profit, there's no interest to pay and no repayment obligation. However, businesses must be careful to ensure they won't need these assets again in the future. Once an asset is sold, it's gone permanently, and the business would need to spend money to replace it if circumstances change.
Reducing stock levels
Businesses can also release cash by cutting down their stock levels (inventory). By holding less stock, the business frees up money that was previously tied up in goods sitting in the warehouse. However, this needs to be managed carefully to ensure the business still has enough stock to meet customer demand.
External sources of finance
External finance comes from outside the business. These sources can be classified by how long the business needs the money: long-term, medium-term, or short-term.
Long-term sources of finance
Long-term finance is typically used for major investments such as buying property, expanding the business, or purchasing expensive equipment. The two main long-term sources are equity and loans.
Equity (shares)
Equity represents money invested in the business by its owners or shareholders. When someone buys shares in a company, they become a part-owner and their investment becomes equity capital.
Key Features of Equity
Equity has several distinctive features that set it apart from other sources of finance:
- It never has to be paid back to shareholders
- There are no interest payments required
- Shareholders can sell their shares if they want their money back, but they sell to other investors, not back to the company
- While shareholders don't receive interest, they may receive dividends (a share of the profits)
For businesses, equity is attractive because it doesn't create debt or ongoing payment obligations. However, bringing in new shareholders can upset existing owners because it dilutes their ownership stake and control over the business. Related to shares are debentures, which are a form of long-term loan secured against company assets, and bank loans for longer-term borrowing.
Loans
A loan involves borrowing money from a lender such as a bank, with an agreement to pay it back over time. Unlike equity, loans must be repaid, and the business must also pay interest (a charge for borrowing the money).
Key features of loans include:
- They must be repaid according to an agreed schedule
- Interest payments are required, usually monthly or annually
- The lender sets a maturity date (when the loan must be fully repaid)
- Loans don't dilute ownership because lenders don't become shareholders
Equity vs Loans: The Key Trade-off
Loans are useful when businesses want to raise money without giving up any ownership or control. However, the obligation to make regular interest payments can put pressure on cash flow, especially if the business hits difficult times. This contrasts with equity, where there's no repayment obligation but ownership must be shared.
Venture capital
Venture capital is finance provided by specialist investors to small and medium-sized businesses that might struggle to raise money through traditional sources like banks. Venture capitalists typically provide funds either as a loan or in exchange for shares in the business.
This source is particularly important for innovative or high-growth businesses that may be seen as too risky by traditional lenders. Venture capitalists often bring expertise and business connections as well as money.
Mortgages
A mortgage is a specific type of loan used to purchase land or buildings. The property itself serves as security for the loan, meaning if the business fails to repay, the lender can take ownership of the property.
Mortgages are long-term loans, often lasting 15-25 years, and are essential for businesses looking to buy their own premises rather than renting.
Crowdfunding
Crowdfunding is a modern method of raising finance where a large number of people each contribute a small amount of money, usually through an online platform. This method has become increasingly popular with the growth of the internet.
Worked Example: Crowdfunding Success
Lunar Missions Ltd, a private moon drilling mission company, successfully raised over $1 million through crowdfunding. This demonstrates how businesses can access funds from many small investors who believe in their project, even for ambitious and unusual ventures.
The company likely attracted hundreds or thousands of individual investors, each contributing anywhere from $10 to several thousand dollars, collectively reaching their fundraising goal.
Medium-term sources of finance
Medium-term finance typically covers periods from one to five years.
Leasing
Leasing allows a business to use an asset (such as machinery or vehicles) without buying it outright. The business makes regular payments to the leasing company for the right to use the asset.
Hire purchase
Hire purchase is similar to leasing but with the key difference that the business eventually owns the asset once all payments are complete. The business uses the asset while paying for it in instalments.
Bank loans
Bank loans can also be used for medium-term finance, typically to fund projects or purchases that will generate returns within a few years.
Short-term sources of finance
Short-term finance covers immediate or near-future financial needs, typically for periods of less than one year.
Bank overdraft
An overdraft is a flexible arrangement where a bank allows a business to spend more money than it currently has in its bank account, up to an agreed limit.
Key features of overdrafts:
- They're very quick and easy to arrange
- The business only pays interest on the amount it's actually overdrawn
- They're extremely flexible – the business can use the overdraft when needed and pay it off when cash comes in
- Overdrafts can be arranged and cancelled quickly
However, interest rates on overdrafts are typically higher than those on loans, making them more expensive if used for long periods. They're best used for managing short-term cash flow gaps.
Debt factoring
Debt factoring (also called invoice factoring) occurs when a business sells its unpaid invoices (bills owed by customers) to a bank or specialist financial institution.
Worked Example: How Debt Factoring Works
Step 1: The business sends invoices to customers for goods or services supplied on credit
Step 2: Rather than waiting for customers to pay, the business sells these invoices to a factoring company
Step 3: The business receives approximately 80% of the money owed immediately
Step 4: When the factoring company collects the full payment from customers, they pay the business the remaining 20%, minus their charges
Example calculation: If a business has invoices totaling $10,000:
- Immediate payment: $8,000 (80%)
- Remaining payment after collection: $2,000 minus factoring fees (perhaps $500)
- Net received: $9,500
This provides immediate cash, which improves cash flow (money moving in and out of the business). It also means the business doesn't have to worry about chasing up late payers. However, debt factoring can be expensive due to the fees charged, and some businesses worry it might damage customer relationships if customers don't like dealing with a third-party collection agency.
Trade credit
Trade credit is an arrangement where a business receives materials, stock, or services from suppliers but doesn't pay for them immediately. Instead, the supplier allows the business to delay payment for an agreed period.
Trade credit periods typically range from one week to several months, depending on the agreement between the business and supplier. This is essentially an interest-free loan from the supplier, which helps improve cash flow. The business can use the goods or materials to generate income before having to pay for them.
Warning: Protect Your Credit Rating
Businesses must be careful to pay within the agreed period. Late payment can damage credit history and harm relationships with suppliers, potentially leading to less favourable terms in the future or even refusal to supply goods.
Comparing sources of finance
Different sources of finance have different advantages and disadvantages. Choosing the right source depends on the business's circumstances, how long the money is needed, and what the business can afford.
Advantages and disadvantages of key sources
Retained profit:
- Advantages: No interest payments required; doesn't need to be repaid to anyone; doesn't dilute shareholders' ownership
- Disadvantages: Only available if the business is profitable; shareholders may be unhappy with reduced dividends
Sale of assets:
- Advantages: No interest to pay; doesn't need to be repaid; doesn't dilute ownership
- Disadvantages: Once sold, the asset is gone permanently and can't be used again if needed
Equity:
- Advantages: No interest payments; never has to be repaid
- Disadvantages: May upset existing shareholders who see their ownership percentage reduced
Loans:
- Advantages: Doesn't dilute shareholders' ownership
- Disadvantages: Interest must be paid regularly; has a set maturity date when it must be fully repaid
Overdraft:
- Advantages: Quick and easy to arrange; very flexible; interest only charged on the amount actually overdrawn
- Disadvantages: Interest rates are typically higher than standard loans
Debt factoring:
- Advantages: Provides immediate cash; improves cash flow; protects against customers who don't pay (bad debts); reduces administration costs
- Disadvantages: Can be expensive due to fees; may affect customer relationships if they don't like dealing with a third party
Trade credit:
- Advantages: Improves cash flow by delaying payment; essentially an interest-free loan
- Disadvantages: Late payment can seriously damage credit history and supplier relationships
Choosing the Right Source
There is no "one size fits all" solution when selecting sources of finance. The best choice depends on:
- The time period the money is needed for
- Whether the business is profitable
- Whether owners want to maintain full control
- The business's ability to make regular repayments
- The cost of the finance (interest rates and fees)
Exam tip
Exam Strategy for Sources of Finance Questions
When answering questions about sources of finance, always consider:
- Whether the business needs the money for the short, medium, or long term
- Whether the business is profitable (affects whether retained profit is available)
- Whether the owners want to maintain control (affects whether equity is suitable)
- The business's ability to make regular repayments (affects whether loans are affordable)
Remember to justify your recommendations with reference to the specific business situation described in the question. Generic answers without context will not score highly.
Remember!
Key Points to Remember:
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Internal sources (retained profit and sale of assets) don't require repayment or interest, but retained profit is only available to profitable businesses
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External sources bring money from outside – they can be long-term (equity, loans, venture capital, mortgages, crowdfunding), medium-term (leasing, hire purchase), or short-term (overdraft, debt factoring, trade credit)
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Equity means giving up ownership stakes but involves no repayment or interest; Loans must be repaid with interest but don't dilute ownership
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Short-term sources like overdrafts and debt factoring help manage immediate cash flow problems but can be expensive
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Always match the source of finance to the business's needs, size, and financial situation – there's no "one size fits all" solution
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Debt factoring provides approximately 80% immediately and the remainder minus charges once collected
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Trade credit is essentially an interest-free loan from suppliers but late payment can damage relationships