Internal Finance (Edexcel A-Level Business): Revision Notes
Internal finance
Why businesses need finance
All businesses require money to start and continue operating. Finance is needed for several purposes:
- Starting up: Purchasing equipment, raw materials and obtaining premises
- Day-to-day operations: Buying stock, paying wages and settling debts as money flows through the business
- Expansion: Acquiring larger premises, additional equipment and hiring more workers
When businesses want to expand beyond what their sales revenue can fund, they must find ways to raise additional finance.
Understanding capital and revenue expenditure
Business expenditure falls into two distinct categories:
Capital expenditure refers to spending on items that can be used repeatedly over time. These are long-term assets such as:
- Company vehicles
- Machinery and equipment
- Buildings and factories
Revenue expenditure covers payments for goods and services that are consumed quickly or immediately. This includes:
- Wages and salaries
- Raw materials
- Fuel and utilities
- Maintenance and repairs of buildings and equipment
Understanding this distinction helps businesses plan which sources of finance are most appropriate for different needs. Capital expenditure typically requires long-term financing solutions, while revenue expenditure is usually funded through short-term sources or operational cash flow.
What is internal finance?
Internal finance is money generated by the business itself or provided by its current owners. Unlike external finance (such as bank loans), internal finance does not involve borrowing from outside sources. There are three main types of internal finance available to businesses.
Owner's capital
Owner's capital represents the money that business owners personally invest into their enterprise. This is often the first source of finance used when starting a business, as most ventures cannot begin without some owner contribution.
Sources of owner's capital
Entrepreneurs typically provide capital from their personal resources:
- Personal savings: Many entrepreneurs deliberately save money over time specifically to fund their business venture
- Redundancy payments: People who lose their jobs sometimes use their redundancy money to start their own business
- Share purchases: Owners of limited companies must buy shares in their business
Owner's capital is not limited to the start-up phase. Business owners can inject additional personal capital later when expansion or other needs arise. This applies to sole traders, partnerships and limited companies alike.
Case study: Ahana Chaudhary's home care business
Worked Example: Owner's Capital in Action
Ahana Chaudhary demonstrates how owner's capital can fund both start-up and expansion. After losing her job at a local hospital, she used:
- $6,000 from her redundancy payment
- $4,000 from personal savings
This $10,000 of owner's capital enabled her to establish a home care service for elderly people in Brighton. The business proved profitable from the outset, allowing her to recruit two full-time staff within five years.
When demand grew significantly, Ahana expanded into operating a care agency. For this expansion, she used $25,000 of retained profit (another form of internal finance) to purchase office premises.
Exam insight: When evaluating owner's capital as a finance source, consider both the risk to personal wealth and the benefit of retaining full control without external interference.
Retained profit
Retained profit is profit after tax that the business keeps and reinvests rather than distributing to owners. This is the single most important source of finance for established businesses.
Why retained profit matters
Much of all business funding across the economy comes from retained profit. It offers several key benefits:
- Cost-effective: No interest charges or administration fees apply
- Flexible: Profit can be accumulated in bank accounts (earning interest) and used when needed
- No external requirements: No credit checks or third-party involvement necessary
The opportunity cost consideration
However, using retained profit involves a significant trade-off. Money retained by the business cannot be returned to owners. This creates different consequences depending on business type:
- Small businesses: Owners and their families have less personal income for their lifestyle
- Limited companies: Shareholders receive lower or frozen dividends
- Public limited companies: This can create conflict between directors (who want to reinvest) and shareholders (who want dividend income)
Some shareholders take a short-term view and demand immediate dividend payments. If directors freeze dividends to fund business activities, this can lead to tension and shareholder dissatisfaction. This represents the opportunity cost of using retained profit - the alternative uses of that money must always be considered.
Limitations
Retained profit is only available to profitable businesses. A business making losses cannot use this source of finance.
Exam technique: When asked to evaluate retained profit, always discuss the opportunity cost and potential for shareholder conflict in your analysis.
Sale of assets
Established businesses can raise finance by selling assets they no longer require or through specialized arrangements.
Types of asset sales
Businesses may sell:
- Obsolete or surplus machinery
- Unwanted stock
- Land and buildings no longer needed
- Entire divisions or parts of the organization
Large corporations sometimes sell significant parts of their business to raise substantial funds. For example:
- Standard Life (financial services provider) sold its Canadian division in 2014 for $2.2 billion to reward shareholders and refocus on UK operations
- The Co-operative Group sold its farms business to the Wellcome Trust for $249 million in 2014 to reduce debt
Sale and leaseback arrangements
Sale and leaseback involves selling an asset the business still needs to a specialist company, then leasing it back for continued use. This increasingly popular option provides:
- Immediate cash injection
- Transfer of maintenance and upkeep responsibilities to the new owner
- Continued use of the asset through the lease
Example: Sale and Leaseback in Practice
In 2014, entrepreneur Duncan Bannatyne sold 39 health clubs to M&G Investments for $92 million, then leased them back. The money helped clear business debts while allowing continued operation of the facilities.
Sometimes businesses face pressure to sell assets when large sums are urgently needed to overcome financial problems.
Advantages and disadvantages of internal finance
Internal finance offers attractive benefits but also presents some limitations that businesses must consider.
Advantages
Immediate availability: Finance is ready when needed. Retained profit sits in bank accounts, and assets can be sold quickly with competitive pricing. No delays waiting for loan approvals or negotiations.
Low cost: Internal finance involves no interest payments, reducing costs and increasing profit margins. Administration costs are also eliminated.
No credit checks required: Businesses avoid the investigations into credit history that external finance providers demand. This saves time and preserves privacy.
No third-party involvement: Owners maintain complete control without external lenders influencing business decisions.
Disadvantages
Limited amounts: A business may not generate sufficient profit for retention, may lack unwanted assets to sell, or owners may have no personal resources available.
No tax benefits: Unlike external finance, internal sources are not tax-deductible. With external finance, interest payments and leasing charges can be treated as business expenses and offset against tax.
Less flexibility: External finance offers numerous options (loans, overdrafts, hire purchase, leasing) that can be tailored to specific needs. Internal finance is more rigid.
No inflation benefits: Inflation reduces the real value of debt over time, benefiting businesses using external finance. Internal finance does not provide this advantage.
High opportunity cost: The alternative uses of internal finance can be significant. Public limited companies must carefully consider shareholder reactions if dividends are cut. Short-term focused shareholders may demand immediate returns, creating conflict with directors' long-term investment plans.
| Advantages | Disadvantages |
|---|---|
| Immediate availability | Can be limited in amount |
| No interest or administration costs | Not tax-deductible |
| No credit checks needed | Less flexible than external sources |
| No third-party involvement | No inflation benefits |
| High opportunity cost |
Exam approach: For evaluation questions, balance these advantages and disadvantages. Consider the business context - a small, profitable business may find internal finance ideal, while a rapidly growing business may need external sources despite the higher costs.
Key Points to Remember:
- Internal finance comes from the business itself or current owners, not from external borrowing
- The three main types are owner's capital (personal savings), retained profit (reinvested profit), and sale of assets (selling unwanted resources)
- Retained profit is the most important internal source for established businesses and the cheapest option with no interest charges
- Opportunity cost is a key consideration - money used in the business cannot be returned to owners, potentially causing conflict especially in PLCs
- Internal finance is immediately available and cost-effective but can be limited in amount and less flexible than external alternatives
- Sale and leaseback allows businesses to raise cash from assets they still need while transferring maintenance responsibilities