Commerce | Sources of finance

💰 Sources of Finance: Fueling the Commerce Engine

Hello future business leaders! This chapter, Sources of Finance, is one of the most critical in Commerce. Think of a business like a car—it needs fuel (money) to start, keep running, and grow.

In this unit, we will learn where businesses get their money from, the pros and cons of different options, and how managers decide which source is best. Don't worry if finance seems tricky; we will break it down into easy, bite-sized pieces!

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Section 1: Why Do Businesses Need Finance?

A business needs money for three main reasons throughout its life:

1. Start-up Capital

This is the money needed before the business even opens its doors. It covers initial costs like buying equipment, renting the first building, and developing products.

2. Working Capital (Day-to-day running)

This is the money needed for everyday expenses. This cash flow keeps the business operational.

• Paying wages and salaries.
• Buying stock or raw materials.
• Paying utility bills (electricity, water).

💡 Quick Tip: If a business runs out of working capital, it could be profitable on paper but still fail because it can't pay its immediate bills! This is called insolvency.

3. Expansion Capital

When a business wants to grow—maybe open a new branch, buy a huge new machine, or enter an overseas market—it needs significant funds for expansion. These tend to be the largest sums of money needed.

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Section 2: Internal Sources of Finance

Internal finance means raising money from inside the business itself. It’s like searching your own pockets before asking a friend for money.

1. Retained Profit

This is the profit the company makes that is kept back in the business rather than being paid out to the owners or shareholders (as dividends).

• Advantage: It is free—no interest is paid, and no debt is created.
• Disadvantage: Only available if the business is already profitable.

2. Sale of Assets

The business sells off assets it no longer needs, such as old machinery, delivery vans, or unused property.

• Advantage: Turns idle assets into immediate cash.
• Disadvantage: The assets sold might be needed again in the future, or the business might receive a lower price than they are worth (a bargain sale).

3. Owner's Capital / Personal Savings

Especially common in sole traders and partnerships, the owner(s) use their own private savings to fund the business.

Example: A baker starting a new shop uses $10,000 they saved from their previous job to buy the first oven.

✅ Key Takeaway (Internal Finance): Internal sources are often the safest because they do not involve borrowing or paying interest. They also mean the owners keep 100% control.

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Section 3: External Sources of Finance (Borrowing)

External finance means raising money from outside the business, usually from financial institutions (like banks) or the public.

We classify external sources based on how long the money is needed for:

• Short-term: Less than 1 year (e.g., covering a temporary cash shortage).
• Medium-term: 1 to 5 years (e.g., buying a new vehicle).
• Long-term: More than 5 years (e.g., buying a factory).

🧠 Memory Aid: Think of clothes sizing: S-M-L (Short, Medium, Long) to remember the timeframes!

A. Short-Term Sources (S)

1. Bank Overdraft

This allows the business to temporarily spend more money than it has in its bank account, up to an agreed limit.

• Pro: Very flexible; only pay interest on the amount actually used.
• Con: Interest rates are usually high, and the bank can demand repayment at short notice.

2. Trade Credit

This is where a supplier allows a business to receive goods now and pay for them later (e.g., '30 days net').

Example: A bookstore receives 100 novels from a publisher today but has 30 days to pay the invoice.

• Pro: It is a free source of finance if paid within the agreed period.
• Con: If payments are late, the supplier may charge high interest or stop supplying goods altogether.

B. Medium-Term Sources (M)

1. Medium-Term Bank Loans

Money borrowed from a bank and repaid over a set period, typically 1 to 5 years. This is common for purchasing assets like delivery vans or small machinery.

• Pro: Payments are fixed and predictable, helping with budgeting.
• Con: Interest must be paid, and the bank may require security (collateral) before lending.

2. Hire Purchase (HP)

The business pays for an asset (e.g., photocopier, kitchen equipment) in installments over time. The business does not legally own the asset until the very last installment is paid.

Analogy: This is like a 'rent-to-own' agreement.

3. Leasing

This is essentially renting an asset (like a car or machinery) for a fixed period. The business never owns the asset; it is returned at the end of the lease.

• Pro: The maintenance and repair costs are often covered by the leasing company. The business avoids the large upfront cost of buying.
• Con: The total cost over the long term can be higher than buying outright, and the business builds no ownership.

C. Long-Term Sources (L)

1. Long-Term Bank Loans (Mortgages)

Used for purchasing very expensive, long-lasting assets like land or buildings (often repaid over 10 to 25 years).

2. Equity Finance: Share Issues (For Limited Companies)

Only limited companies (Ltd or PLC) can sell shares. A share represents a part-ownership of the company. When a company issues (sells) new shares, they raise cash.

• Pro: The money raised never has to be repaid, unlike a loan.
• Con: Selling shares dilutes (reduces) the ownership percentage of existing owners, meaning they lose control. Shareholders also expect a return (dividends).

3. Debentures (Loan Stock)

Used mainly by large Public Limited Companies (PLCs). A debenture is essentially a long-term loan certificate issued to investors, promising to pay them back on a fixed date, with a fixed rate of interest (coupon rate).

Think of a debenture as a corporate IOU (I Owe You) for a fixed time period, typically 10 years or more.

4. Grants and Subsidies

Money given, usually by the government or European Union, to encourage businesses to undertake certain activities (e.g., move to a specific region, use environmentally friendly technology, or hire unemployed people).

• Pro: Generally, grants do not have to be repaid (unless the conditions are broken).
• Con: They are difficult to obtain, often involve a lot of paperwork, and usually come with strict conditions.

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Section 4: The Decision-Making Process: Choosing the Right Source

Choosing the right source of finance is crucial. A poor choice can lead to high interest payments or even the loss of control over the business. Business owners must consider several factors:

1. The Purpose of the Finance

This is the golden rule: The source must match the need.

• Common Mistake to Avoid: Using a short-term overdraft (high interest) to pay for a long-term asset like a new factory. You would end up paying back the full amount before the factory even generated enough revenue!
• Rule: Long-term needs require long-term finance.

2. The Cost

This is usually measured by the interest rate. Borrowing is cheaper if the interest rate is lower. However, costs also include bank charges and administrative fees.

3. Security (Collateral)

Banks often require security—an asset the business owns that the bank can seize and sell if the loan is not repaid.

Example: A business uses its factory building as security for a large loan. If they default, the bank takes the factory.

4. The Amount Required

If the business needs a small amount for a few weeks, an overdraft or trade credit is sensible. If it needs millions for a new factory, only long-term loans or share issues will suffice.

5. Risk and Control

Does the source increase the risk to the owners?

• Debt Finance (Loans, Debentures): Increases risk because if repayments are missed, the business could face bankruptcy. However, owners keep full control.
• Equity Finance (Share Issues): Lowers the risk of debt, but the original owners give up control and decision-making power to the new shareholders.

You've made it through the finance chapter! Remember, understanding where the money comes from is the first step to running a successful and sustainable business.

Keep up the great work!