Financing growth (Edexcel GCSE Business): Revision Notes
Financing growth
What is financing growth?
When businesses want to expand and grow, they need additional funding to support this development. Companies can obtain this funding through two main approaches: using money from within their existing operations or seeking financial support from external sources.
Understanding the distinction between internal and external financing is crucial for making informed business decisions. Each approach has different implications for ownership, control, and financial risk.
Sources of finance for business growth
Understanding the different funding options available helps businesses make informed decisions about how to finance their expansion plans.
Internal sources of finance
Internal financing uses money that already exists within the business operations.
Sale of assets
Businesses often own various assets, including equipment, machinery, property, or excess stock that may no longer be essential for daily operations. When companies sell these assets, they can generate immediate cash to fund growth initiatives.
This approach comes with a significant trade-off. Once an asset is sold, the business loses the benefits of owning it. For example, selling a delivery van might provide cash for expansion, but the company would then need to find alternative ways to transport goods.
This makes asset sales suitable mainly for items that are genuinely surplus to requirements.
Retained profit
This represents the most secure method of financing growth. Retained profit consists of earnings that the business has generated but chosen not to distribute to owners or shareholders. Instead, these funds are kept within the company for future investment.
The major advantage of using retained profit is that it involves no external debt or financial risk. The business doesn't need to pay interest or give up ownership stakes. However, not all companies generate sufficient profit to fund substantial growth plans, making this option potentially limiting for ambitious expansion projects.
Retained profit is particularly valuable because it represents money the business has already earned through successful operations, making it a proven source of funds that doesn't create additional financial obligations.
External sources of finance
External financing involves obtaining money from sources outside the business.
Loan capital
Banks and other financial institutions can provide loans specifically for business growth. These loans are typically secured against the company's assets, meaning the lender has legal claim to certain business property if repayments cannot be made.
The key characteristic of loan capital is the requirement for regular repayments with added interest charges. This creates a fixed financial commitment that the business must meet regardless of its performance.
While loans provide immediate access to funds, they also create ongoing financial obligations that can strain cash flow, particularly if the business experiences difficulties. Failure to meet repayment schedules can result in serious consequences, including potential loss of secured assets.
Share capital
Companies can raise funds by selling ownership shares to investors. This approach is particularly relevant for public limited companies (PLCs) that can sell shares on stock exchanges.
When businesses sell shares, they obtain immediate capital without creating debt. However, this comes at the cost of giving up partial ownership and control. New shareholders become entitled to vote on company decisions and receive a portion of future profits through dividends.
Share capital is especially useful for companies with strong growth potential, as investors are often willing to pay premium prices for shares in businesses they believe will become more valuable over time.
This makes share capital a viable option for growth, but one that fundamentally changes the ownership structure of the business.
Comparing different sources of finance
When choosing between financing options, businesses must consider several important factors.
Risk considerations
Different funding sources carry varying levels of risk. Selling shares might result in owners losing control of their business, while loans create the risk of cash flow problems if repayment schedules cannot be met. Using retained profit carries the least risk since it doesn't create external obligations.
Cost variations
The expense of obtaining finance differs significantly across sources. Loans require interest payments, while selling shares means sharing future profits with new owners. Retained profit and asset sales typically have lower direct costs, though asset sales involve opportunity costs from losing ownership benefits.
When calculating the true cost of financing, businesses should consider both immediate expenses (like interest payments) and long-term implications (like sharing future profits with shareholders).
Availability factors
Not all financing options are accessible to every business. Some sources, such as loans or share capital, might not be available to certain companies due to their size, creditworthiness, or legal structure. Businesses must work within the constraints of what funding sources they can actually access.
Practical application
Worked Example: Bank Loan for Growth
Consider a business borrowing £50,000 from a bank to finance growth at 8% annual interest over 5 years.
Monthly repayment calculation:
- Total interest = £50,000 × 8% × 5 = £20,000
- Total repayment = £50,000 + £20,000 = £70,000
- Monthly payment = £70,000 ÷ 60 months = £1,167
Risk assessment: If the business struggles to generate sufficient cash flow to meet these regular £1,167 monthly payments, it could face serious financial difficulties, including potential loss of assets used as security.
This demonstrates why businesses must carefully consider their ability to service debt when choosing external financing options.
Key Points to Remember:
- Internal finance comes from within the business (retained profit, asset sales), while external finance comes from outside sources (loans, shares)
- Retained profit is the safest financing option as it involves no debt or loss of control
- Loans provide immediate funds but create ongoing repayment obligations with interest
- Share capital raises money without debt but involves giving up ownership and profit-sharing
- Always consider risk, cost, and availability when comparing financing options