Business management | Sources of finance

Hello IB Students! Conquering Unit 3.2: Sources of Finance

Welcome to the heart of the Finance and Accounts section! Understanding Sources of Finance is absolutely crucial because every single business decision—whether it's launching a new product, hiring staff, or building a factory—requires money.

Think of finance as the fuel that keeps the business engine running. In this chapter, we learn where businesses find that fuel and how they choose the best type for their needs. Don't worry if the terminology seems heavy; we'll break it down using simple analogies!

Why is Choosing the Right Source of Finance Important?

• It affects liquidity (can the business pay its short-term bills?).
• It determines the level of risk (does the business have high interest payments?).
• It impacts control (does the owner have to give up a share of the business?).

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Section 1: Internal vs. External Sources

The first major way to classify finance is based on where the money comes from: inside the business or outside the business.

1. Internal Sources of Finance

Definition: Internal sources of finance come from within the business itself; no external party is involved.

Analogy: This is like finding money in your own piggy bank or selling something you already own.

Key Internal Sources:

• Retained Profits (The King of Internal Finance):
  This is the profit that a company keeps after paying taxes and distributing dividends to shareholders.
  • Advantage: It's free! (No interest payments or repayment deadlines).
  • Disadvantage: Only available if the business is profitable.
• Sale of Assets:
  A business sells off unwanted or unused fixed assets, such as old machinery, vehicles, or even land.
  • Advantage: Provides a large lump sum quickly.
  • Disadvantage: The assets can only be sold once, and the business loses the use of them (if they were still occasionally useful).
• Working Capital Reduction:
  This involves managing current assets more efficiently, often by reducing inventory (stock) or collecting money from debtors (people who owe the business money) faster.
  • Example: Pushing customers to pay their invoices sooner (reducing 'Trade Receivables').

2. External Sources of Finance

Definition: External sources come from outside the business, often involving taking on debt or selling ownership (equity).

Analogy: This is borrowing from the bank, asking family, or finding an investor.

External finance can be further divided into two types: Debt (borrowing) and Equity (selling ownership).

A. Equity Finance (Selling Ownership)

Equity finance involves selling a stake in the company in exchange for cash. This money does not need to be repaid.

• Share Capital (or Flotation):
  Selling shares of the business to investors, often via a Stock Exchange (called a flotation or Initial Public Offering - IPO).
  • Advantage: Huge amounts of capital can be raised; no interest payments.
  • Disadvantage: Original owners lose control, and future profits must be shared via dividends.
• Venture Capital (VC) and Business Angels:
  These are external investors (often wealthy individuals or specialized firms) who provide capital to high-risk, high-growth start-ups in exchange for a significant equity stake and usually a role in management.
  • Did you know? Business Angels typically invest their own money, while Venture Capitalists manage funds raised from others.

B. Debt Finance (Borrowing)

Debt finance involves borrowing money that must be repaid, usually with interest.

• Loans (Term Loans):
  Money borrowed from a bank or financial institution for a specific period (medium to long-term), repaid in fixed installments.
  • Advantage: Interest is tax-deductible; ownership structure remains unchanged.
  • Disadvantage: Requires collateral (security) and involves interest payments regardless of profitability.
• Overdrafts:
  The bank allows a business to spend more money than is currently in its account, up to a pre-agreed limit. This is purely a short-term source.
  • Advantage: Very flexible and immediate solution for short-term cash flow problems.
  • Disadvantage: Very high interest rates.
• Trade Credit:
  When suppliers allow the business to purchase goods or materials immediately but pay for them later (e.g., 30 or 60 days). This is the most common form of short-term debt.
  • Advantage: Essentially a free loan for the credit period.
  • Disadvantage: If not paid on time, relationships with suppliers are ruined, or future discounts may be lost.
• Grants and Subsidies:
  Financial assistance provided by the government, often to promote certain activities (like R&D or expansion into disadvantaged areas).
  • HUGE Advantage: They usually do not need to be repaid!
  • Disadvantage: They often come with strict conditions and can be difficult to obtain.
• Leasing and Hire Purchase:
  Both allow a business to acquire assets without a large upfront capital payment.
  • Leasing: Renting an asset (like a car or machinery) over a set period. The business never owns the asset.
  • Hire Purchase: Similar to leasing, but payments eventually lead to ownership of the asset.

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Section 2: Choosing Finance by Time Period (Duration)

A key skill in finance is matching the source of finance with the time frame of the need. You wouldn't take out a high-interest credit card (short-term) to pay for a 20-year factory (long-term)!

1. Short-Term Finance (Less than 1 Year)

Used to finance day-to-day running costs and manage temporary working capital shortfalls (e.g., waiting for customer payments).

• Key Sources: Overdrafts, Trade Credit.
• Internal Source: Working Capital Reduction (e.g., better inventory control).

2. Medium-Term Finance (1 to 5 Years)

Used to purchase assets that have a useful life longer than one year, such as equipment upgrades or larger inventory purchases.

• Key Sources: Bank Term Loans (Medium-Term), Hire Purchase, Leasing.
• Internal Source: Retained Profits (if available).

3. Long-Term Finance (More than 5 Years)

Used for significant capital expenditure, such as buying land, building a new headquarters, or financing long-term expansion projects. These sources usually carry the lowest annual interest rate but bind the business for many years.

• Key Sources: Share Capital (Equity), Long-Term Bank Loans, Mortgages (loans secured against property), Venture Capital.

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Chapter Summary: Key Takeaways

Congratulations! You now have a solid foundation for understanding how businesses fund their activities. Remember these crucial points for your IB exams:

• Matching is key: A business must match the time frame of the investment (e.g., building a factory) with the time frame of the finance (e.g., a long-term loan).
• Internal is usually safer: Internal finance (like retained profits) is preferred because it avoids interest and doesn't dilute ownership, but it might not be enough.
• External means trade-offs: External debt (loans) is cheap if interest rates are low but adds risk. Equity (shares) is safer but means losing control.

Keep practicing those definitions and linking the source of finance to specific business needs. You've got this!