Sources of finance (AQA GCSE Business): Revision Notes

Sources of finance

Introduction to business finance needs

Every business requires funding to operate successfully, whether it's a brand new venture just getting started or an established company looking to expand. Understanding why businesses need finance is crucial for making informed decisions about funding sources.

Businesses typically require finance for several key purposes. When starting up, companies need funds to cover initial expenses such as legal fees, premises, and equipment - these are one-time costs that must be paid before any trading can begin. Additionally, businesses need money to prepare for production, including purchasing raw materials, covering initial marketing expenses, and paying staff wages before sales revenue starts flowing in.

Once operational, businesses face ongoing running costs including materials, labour, utilities, and other regular expenses that should ideally be covered by sales income. However, businesses may also need emergency funding when facing unexpected challenges, such as new competition or economic downturns. Finally, most successful businesses eventually seek growth finance to expand their operations, invest in larger premises, or purchase additional equipment.

Internal sources of finance

Internal finance refers to money that comes from within the business itself, rather than from external lenders or investors. These sources are often preferred because they typically don't require repayment terms or interest charges.

Retained profits

For established and profitable businesses, reinvesting profits represents the most significant internal funding source. When a company generates profits, the owners or shareholders can choose to either withdraw these profits as dividends or reinvest them back into the business for future growth.

This financing method offers several compelling benefits. Firstly, it's cost-effective since no interest payments are required. Management maintains complete flexibility over how these funds are used and in what proportions they're allocated to different projects. Importantly, using retained profits doesn't dilute ownership control, as would happen when selling shares to external investors.

However, retained profits also have limitations. Businesses experiencing financial difficulties are unlikely to have available profits to reinvest. Some critics argue that companies may hoard cash unnecessarily when shareholders could invest it more productively elsewhere. Additionally, businesses dependent solely on retained profits may experience slower growth compared to those willing to use external financing.

Selling unwanted assets

Companies can generate additional funding by disposing of assets they no longer need. This might include spare land, outdated equipment, or unused buildings that can be sold to raise capital on a one-off basis.

The primary advantage of asset sales is that no repayment is required, and business owners retain full control over their operations. However, this approach has significant drawbacks. It's typically not a sustainable long-term funding solution since assets can only be sold once. Furthermore, selling assets may reduce the business's overall value and operational capacity.

Personal finance and owner's funds

Many entrepreneurs, particularly those starting small businesses, rely on their personal savings, inheritance, or even lottery winnings to fund their ventures. This might involve using personal savings accounts, cashing in investments, or using personal assets as collateral.

Personal finance represents an accessible and inexpensive funding option that demonstrates the entrepreneur's commitment to potential investors and lenders. However, it puts the owner's personal financial security at risk and may not provide sufficient capital for larger business ventures.

Taking on additional partners

Sole traders and existing partnerships can raise finance by bringing in new partners who contribute capital to the business. While this provides additional funding without the need for loan repayments, it also means sharing control and future profits among more people.

External sources of finance

External finance involves obtaining money from sources outside the business. These options are particularly important for start-ups and growing businesses that need more capital than internal sources can provide.

Friends and family

For many new businesses, friends and family represent the primary external funding source. These individuals may be willing to invest substantial amounts for extended periods at low or no interest rates, and they often prefer not to interfere with day-to-day business operations.

The benefits for entrepreneurs include potentially favourable terms and patient capital. However, involving personal relationships in business can create complications. Friends and family may want involvement in business decisions, and relationship difficulties can arise if the business struggles or fails.

Mortgages and re-mortgaging

Property-based borrowing provides another external financing option. A mortgage involves taking a long-term loan to purchase business premises, while re-mortgaging means taking additional borrowing against existing property.

This approach offers relatively low-cost finance that can be repaid in manageable monthly instalments over many years. However, significant risks exist - business failure could result in losing the property. Additionally, many mortgages have variable interest rates, making future payments unpredictable. Some form of security or collateral is typically required before banks approve mortgage applications.

Trade credit

Many businesses use trade credit as a short-term financing solution. This arrangement allows companies to receive goods from suppliers immediately while paying for them at a later date, typically 30-90 days after delivery.

Trade credit can improve cash flow by allowing businesses to use goods and generate sales revenue before paying suppliers. However, late payments can damage relationships with suppliers and harm the business's credit reputation. New businesses may find it particularly challenging to negotiate trade credit terms, and there's always a risk that struggling businesses may fail to pay suppliers entirely.

Bank overdrafts

Banks offer overdraft facilities as flexible short-term financing options. An overdraft allows businesses to withdraw more money from their account than they actually have, up to an agreed maximum limit, and is only used when additional funds are needed.

The main advantage of overdrafts is their flexibility - businesses can access funds immediately when facing unexpected costs or temporary cash flow problems, and interest is only charged on the amount actually used. However, overdrafts can be expensive due to high interest rates, and banks can withdraw the facility at any time. This became a particular problem during the 2007-8 financial crisis when many banks reduced or cancelled overdraft facilities, causing significant difficulties for businesses that relied on them.

Bank loans

Bank loans provide a fixed amount of money borrowed for a specified period with an agreed repayment schedule. The repayment amount depends on the loan size, duration, and interest rate.

Banks typically prefer lending to well-established, growing businesses rather than start-ups, as this reduces their risk exposure. Successful loan applications offer several advantages: businesses receive guaranteed funding for a specific period (usually three to ten years), and loans can be structured to match the expected lifespan of assets being purchased.

Bank loans also offer additional benefits. Interest payments are required, but the bank doesn't gain any ownership stake in the business, preserving management control. Interest rates may be fixed, making cash flow forecasting more predictable. Repayments are typically made in instalments, allowing businesses to access substantial capital without immediate full repayment.

However, bank loans also present disadvantages. Security is normally required, giving the bank control over business assets if repayments fail. Lack of flexibility means businesses may pay interest on unused portions of loans. Interest payments increase overall business costs regardless of profitability.

Selling shares and flotation

Both private and public limited companies can raise substantial finance by selling ownership shares. For private companies, this might involve selling shares to friends, family, or private investors. Public companies can raise much larger amounts through flotation - selling shares on the stock market for the first time.

Flotation significantly expands the potential investor base, allowing thousands of individuals and institutional investors like pension funds to invest in the business. However, this may result in original owners losing some or complete control over the business they built.

Share financing offers several advantages: large amounts of capital can be raised, the money doesn't need to be repaid, and dividend payments can be reduced or eliminated during difficult periods. However, disadvantages include potential loss of control if original owners sell more than 50% of shares, and the need to satisfy shareholder expectations regarding dividends and share price performance.

Grants

Government agencies or charitable organisations sometimes provide grants to support new or expanding businesses, particularly in areas of economic need or high unemployment. These grants are typically linked to specific objectives, such as job creation or regional development.

The primary advantage of grants is that they're essentially free money that doesn't require repayment. However, grants often come with conditions, such as requirements to employ local workers or locate in specific areas that may not be optimal for the business. Government grants can be extremely difficult to obtain due to extensive paperwork and competition from other applicants.

Alternative sources: hire purchase and leasing

While not technically sources of finance, hire purchase and leasing arrangements allow businesses to use equipment or products while making payments over time. This improves cash flow and provides access to assets that might otherwise be unaffordable.

Hire purchase involves gradually purchasing items through instalments, with ownership transferring after the final payment. However, total payments typically exceed the original product value due to interest charges. Leasing is similar to rental agreements where businesses never own the product, though upgrades are often possible. This approach is particularly popular for technology equipment like computers and photocopiers.

Factors affecting choice of finance source

Selecting the most appropriate financing source depends on several crucial factors that businesses must carefully evaluate.

Business profitability plays a significant role in financing decisions. Companies with strong profit records can often fund expansion through reinvested earnings rather than seeking external finance. Conversely, businesses lacking profitability may need to rely on more expensive external financing options.

Management quality and experience heavily influence financing decisions. Banks carefully assess the abilities and track record of business leadership teams to determine lending risks. Experienced management teams with proven success records typically find it easier to secure external financing on favourable terms.

The intended use of finance also affects source selection. Long-term growth projects, such as purchasing warehouses or factories, are better suited to long-term financing options like bank loans or share capital. Short-term needs are more appropriately met through overdrafts or trade credit arrangements.

Legal structure significantly impacts available financing options. Public limited companies can raise finance through public stock markets, while private limited companies can issue shares to family and friends. Sole traders and partnerships cannot sell shares, though sole traders can change their legal structure to become partnerships, and existing partnerships can take on additional partners.