0264 · 5.1.2The main sources of finance

Finance basics and internal sources

0:00A shop needs extra money for seasonal inventory, while a manufacturer wants to build a factory. Both need finance, but their needs last very different lengths of time. Choosing suitable funding helps each business meet its payments without taking unnecessary risks. This video explains where finance comes from and how to justify a suitable choice. Business finance is the money required to carry out business activities. Cash is the money a business holds as notes and coins and in its bank account.

0:27A source of finance is where a business obtains money, or an arrangement that lets it delay a payment. Each source brings different costs, commitments and effects on ownership. Revenue is the income a business receives from selling goods or services, while profit is total revenue minus total costs. Borrowing has its own cost. Interest is the payment made for borrowing money. Keep these meanings separate when choosing finance, because a profitable business can still need cash before customers pay.

0:56Internal sources of finance come from within the business. The four internal sources are owners’ investment, retained profit, sale of unwanted assets and working capital. Finance from outside the business is called external finance. Its nine sources are share capital or issuing shares, venture capital, bank overdrafts, leasing, hire purchase, bank loans, trade credit, government grants and crowdfunding. Owners’ investment is the owners’ own savings put into the business. The syllabus treats it as internal finance because the owners are part of the business.

1:28For example, the owner of Juniper Salon could put ten thousand dollars of savings into new styling chairs. The business gains funding without interest or scheduled repayments, and the owner keeps full control. However, the amount is limited by personal savings, and the owner risks losing that money if trading fails. Retained profit is profit kept in the business instead of being paid to the owners. An established café could use this to replace its seating.

1:53The business avoids interest, and ownership stays unchanged because no additional investor joins. Owners receive less money immediately, however, and the amount available depends on previous trading success. A new business has no previous profit to retain. Even an established business must check how much cash is available before spending retained profit. Some previous earnings may already be tied up in equipment or in amounts customers owe. Retaining profit provides a potential source of funding, but actual payments require accessible cash.

2:24Sale of unwanted assets means raising money by selling resources the business no longer needs. An unused machine or spare piece of land could provide funds without borrowing. The business may also save storage or maintenance costs because it stops holding the resource. However, finding a buyer takes time, and the money raised depends on the sale price. A new business usually has few spare assets, so this source mainly suits established firms.

2:49Working capital is current assets minus current liabilities. Current assets are resources expected to become cash or be used within one year. Current liabilities are amounts the business must pay within one year. Working capital supports everyday operations, and managing it carefully can release cash for other uses. Inventory is the goods and materials a business holds, for use in production or for sale. Reducing excess inventory releases cash when those goods are sold.

3:17Trade receivables are the money owed to a business by customers who bought on credit. Collecting trade receivables sooner makes funds available earlier. These methods use resources already within the business, so extra borrowing can be avoided. The disadvantage is pressure on everyday operations if managers release too much cash. Insufficient inventory can leave customers unable to buy what they want. Stricter payment terms may persuade customers to choose another supplier.

3:42The business benefits when it releases genuinely spare resources while protecting reliable service and customer relationships. Internal finance generally brings no interest, scheduled repayments or loss of ownership control. These advantages protect the business from additional payment commitments. However, available amounts are limited by savings, previous profit and existing resources. Using these funds also leaves less available for other needs, so managers must preserve enough cash for routine payments.

External sources of finance

4:11A share is a unit of ownership in a limited company. Anyone holding shares is a shareholder, and so owns part of the company. Share capital is the money raised by issuing shares, and only limited companies can use this source. A public limited company can sell shares to the general public, usually through a stock exchange. Shares in a private limited company, by contrast, go only to investors the existing owners choose, such as family members and friends.

4:35The company gains funds without interest or a requirement to repay the share capital. This suits expensive projects whose benefits develop over several years. A dividend is a payment made to shareholders out of profit. Investors usually expect dividends or a rising share value in return. Existing owners may lose some control because the new shareholders gain voting rights. Venture capital is finance from specialist investors for new or small businesses with high growth potential, in return for a share of ownership.

5:04These investors also give advice, which can help managers develop products and expand successfully. The business gains funding without scheduled loan repayments. However, its original owners surrender part of their ownership and may face pressure for rapid growth. A bank overdraft allows a business to spend more than its account balance, up to an agreed limit. This gives flexible short-term finance when payments fall due before customers pay. Interest applies to the amount actually overdrawn, so the business can borrow only what it needs.

5:34However, interest rates are often high, and the bank can withdraw the facility. Leasing means paying a regular fee to use an asset without owning it. A delivery service can obtain a vehicle without paying its full purchase price immediately. Maintenance is often included, so the business may avoid unexpected repair bills. Over time, leasing can cost more than buying, and ownership remains with the leasing company. With hire purchase, a business buys an asset through a deposit and regular instalments, and ownership passes after the final payment.

6:03A farm could obtain a tractor while spreading its purchase cost. The business eventually owns the equipment and can continue using it. Interest increases the total amount paid, and missed instalments can lead to the asset being taken back. A bank loan is a sum borrowed for a fixed period and repaid with interest in instalments. It can provide a substantial amount for premises or machinery. Predictable instalments help the business plan its payments.

6:27However, interest increases costs, and repayments continue even during periods of weak sales. Security is an asset pledged to a lender that can be taken if borrowing is not repaid. Banks usually require this protection before approving a substantial loan. The borrower therefore risks losing the pledged resource if payments stop. A business with few suitable assets may struggle to obtain the amount it wants. Trade credit means suppliers provide goods now and allow the business to pay later.

6:56Payment is often due after thirty to sixty days. The buyer can sell goods before paying its supplier, which reduces the immediate need for cash. Usually no interest is charged within the agreed period, but discounts for early payment may be lost. A government grant is money given to a business that does not have to be repaid, often with conditions attached. Grants reduce the amount a business must borrow, so interest costs can be avoided.

7:19However, eligibility rules restrict which businesses qualify. Conditions may also control how the money is used, so the scheme must fit the proposed project. Crowdfunding raises money from a large number of people, usually online, with each providing a small amount. A campaign can publicise a new product while collecting funds for its launch. However, platform fees reduce the amount the business receives, and its target may remain unmet. Publishing the idea also allows potential competitors to copy it.

7:48The commitments attached to crowdfunding depend on the arrangement. Supporters might receive a reward, part ownership or repayment with interest. Rewards cost money to supply, ownership reduces the original owners’ control, and repayment adds interest. The business must check those promises before choosing a platform.

Choosing suitable finance

8:07External finance can raise much larger amounts than internal sources, so it suits big projects such as a new factory. Some sources bring extra benefits, such as advice from venture capital investors or publicity from crowdfunding. The owners also keep their personal savings. However, borrowing adds interest and repayments, which raise costs and put pressure on cash. Selling shares reduces the original owners’ control, and lenders may demand security. The main selection factors are size of business, legal form, amount required, length of time, existing loans, cost and purpose.

8:40Each factor helps managers test whether a source fits their circumstances. A method can be available yet still create unsuitable payment commitments. Good decisions connect the funding arrangement to the business’s actual needs. Size of business affects access to finance because lenders and investors judge how safe their money will be. A large established manufacturer has more assets to offer as security and a record of profits. Banks therefore lend to it more readily, often at lower interest rates.

9:08A small new café may have to rely on owners’ investment, trade credit or a small overdraft. Legal form decides which sources are possible at all. Sole traders and partnerships cannot issue shares, so they depend on owners’ investment, loans and other sources. Only limited companies can raise share capital. Among them, only a public limited company can sell shares to the general public, so it can raise the largest amounts this way.

9:33The amount required determines whether a source can realistically cover the need. Selling a small unused machine may fund replacement furniture, while a factory requires much more money from shares or a large loan. Small sums are often too expensive to raise through a share issue because of its fees. Large sums may be beyond what an overdraft or trade credit can provide. Length of time concerns how long the funding is needed.

9:55Needs that last a few weeks or months, such as seasonal inventory or wages, suit short-term finance like an overdraft or trade credit. Non-current assets such as buildings and machinery need long-term finance, for example a bank loan or share capital. Those assets earn money over many years, so the repayments can be spread across that period. Existing loans matter because their instalments already place demands on cash. Additional borrowing increases those commitments and can make lenders less willing to approve funds.

10:25Cost includes interest, fees and any discounts given up. A hotel should compare the full cost of an overdraft with the value of an early-payment discount lost through trade credit. Purpose concerns what the business needs the finance to achieve. Leasing can provide access to machinery when use matters more than ownership. Trade credit helps fund goods bought from suppliers because payment is delayed. A suitable grant may support a particular expansion project, provided its conditions match the intended spending.

Worked example: seasonal inventory

10:54In Paper One Short Answer and Data Response and Paper Two Case Study, use the stimulus information to support your choices. Justify means support a case with evidence or argument. A strong answer selects one source, develops reasons from the case and explains why the strongest alternative is weaker. Yarrow Gifts sells decorations and operates as a small sole trader. Its owner aims to meet seasonal demand and needs four thousand dollars of inventory for one month.

11:20Customers are expected to pay fifty-five hundred dollars before the supplier’s bill falls due. The supplier offers thirty days of trade credit without interest or any lost discount. A bank offers an overdraft covering the purchase, with total interest and fees of sixty dollars. As a sole trader, the owner cannot issue shares, so the choice lies between these two offers. Assume all expected customer receipts arrive on time and other operating payments are covered separately.

11:46Consider both arrangements before choosing the better fit. First, compare the cash left after paying for the inventory. Fifty-five hundred dollars minus four thousand dollars gives fifteen hundred dollars under trade credit. For the overdraft, fifteen hundred dollars minus sixty dollars leaves fourteen hundred and forty dollars. Trade credit leaves sixty dollars more available because the agreed delay carries no financing charge. I recommend trade credit for Yarrow Gifts. The thirty-day payment period matches its one-month seasonal need, and expected customer receipts arrive before the supplier requires payment.

12:20The arrangement also preserves sixty dollars because no interest or early-payment discount is sacrificed. An overdraft is weaker here because its flexibility adds a charge without improving the timing match. The owner must monitor customer receipts because the supplier still needs payment on the agreed date. That obligation remains even if seasonal sales disappoint. On the stated assumptions, trade credit covers the purchase without an extra financing charge. It is therefore the better choice for meeting seasonal demand while preserving cash.

Worked example: factory expansion

12:49Northgate Engineering produces vehicle parts and operates as a large public limited company. It aims to expand output through a new factory costing two million dollars. Investors are willing to buy newly issued shares worth two point three million dollars. The existing owners accept wider ownership to support this expansion. Alternatively, a bank offers a loan of two point three million dollars with total interest of seven hundred thousand dollars.

13:14Existing loan payments already strain the company’s cash. Assume both offers are available and other financing charges are covered separately. The question asks you to justify which source best supports the expansion. Two point three million dollars minus two million dollars leaves three hundred thousand dollars after paying for the factory. Both offers therefore cover the project and leave a reserve. For the loan, two point three million dollars plus seven hundred thousand dollars gives three million dollars of total repayments.

13:41Those payments would add to commitments already straining cash. I recommend issuing shares for Northgate Engineering. The funding matches a long-term factory investment without adding compulsory loan instalments to existing cash pressure. It also leaves three hundred thousand dollars available after construction, which provides a reserve during expansion. The bank loan is weaker because its interest raises total repayments to three million dollars. Existing owners would share control with additional investors, and shareholders would expect dividends.

14:11However, the case states that wider ownership is acceptable. Issuing shares therefore fits both the company’s legal form and its financial position. This choice supports expansion while protecting cash needed to keep production operating. Keep the important distinctions clear when answering. Profit measures trading performance, while cash pays bills when they fall due. Leasing provides use of an asset, while hire purchase transfers ownership after the final instalment. Only a public limited company can offer shares to the general public, and each funding method brings its own specific commitments.

14:44Internal sources of finance come from within the business, while external ones come from outside it. Choose between them by matching the amount, timing and purpose to the business’s size, legal form and existing commitments. A justified recommendation uses case evidence to show why one source best supports the intended outcome.