Welcome to Business Finance: Sources of Money!
Hello future business leader! This chapter is all about where businesses find the essential resource they need to survive and grow: money (or finance). Think of finance as the fuel that keeps a car running—without it, the business engine stops!
Don’t worry if terms like ‘retained profit’ or ‘venture capital’ sound tricky right now. We will break down every source into simple, manageable pieces. By the end of these notes, you’ll be able to confidently advise any business owner on the best way to get cash!
Why is Understanding Finance Sources Important?
- Every business, from a small corner shop to a huge multinational corporation, needs money.
- Using the wrong type of finance can lead to serious problems (like high interest payments).
- Knowing the options helps businesses plan for the future, whether they are just starting up or looking to expand globally.
Section 1: Internal vs. External Finance – The Big Divide
When a business needs money, the first big question is: Should we look inside the business or outside the business?
This gives us the two fundamental categories of finance:
1. Internal Sources of Finance
Internal sources are funds that come from inside the business itself. It’s money the business already owns or has generated.
Think of it this way: If you need £50, checking your piggy bank is an internal source!
2. External Sources of Finance
External sources are funds raised from outside the business. This usually means borrowing money or bringing in new investors.
Think of it this way: If your piggy bank is empty, asking your parents or the bank for £50 is an external source!
Quick Review: Internal vs. External
Internal: Quick, no interest charges, but limited amount.
External: Large amounts possible, but usually involves interest or giving away ownership.
Section 2: Internal Sources of Finance (Money From Within)
These are often the easiest and cheapest ways to get funding, as you don't owe anyone else.
1. Retained Profit
Definition: This is the profit made by the business that is kept back to be reinvested into the company, rather than being paid out to the owners or shareholders.
- Only profitable businesses can use this source.
- It costs nothing (no interest or fees).
- It is readily available immediately.
Did you know? Large, well-established businesses often fund huge expansion projects solely using retained profits!
2. Sale of Assets
Definition: Selling off unwanted or unused items the business owns (like old machinery, spare land, or outdated computers) to raise cash.
- This is useful if the asset is no longer needed or if the company is downsizing.
- The money raised is usually a one-off amount.
3. Owner’s Capital (or Personal Savings)
Definition: The owners (especially in small businesses like Sole Traders or Partnerships) inject their own private savings into the business.
- This is very common when a business first starts up.
- It shows great commitment from the owner, which might make external investors more confident later.
Key Takeaway for Internal Finance: Internal sources are great because they are cheap (no interest) and quick, but their availability depends entirely on how much money the business or its owner already has.
Section 3: External Sources of Finance (Money From Outside)
External sources are needed when internal sources are either unavailable or insufficient (not enough money). These sources are typically divided based on how long the money is needed for.
A. Short-Term Finance (Needed for less than 1 year)
Short-term finance is generally used to solve working capital problems—paying bills, wages, or covering unexpected shortfalls.
1. Overdrafts
Definition: An agreement with the bank allowing the business to withdraw more money than it currently has in its account, up to an agreed limit.
- Advantage: Extremely flexible and quick to arrange. Perfect for unexpected short-term cash flow problems.
- Disadvantage: The bank charges a very high rate of interest (often higher than a normal loan). They must be paid back quickly.
Analogy: An overdraft is like a credit card for your bank account. It’s there for emergencies, but you must pay it off fast or the cost spirals!
2. Trade Credit
Definition: When a supplier provides goods or raw materials to a business but allows them a period of time (e.g., 30, 60, or 90 days) before payment is due.
- If managed well, it is a free source of short-term finance.
- It improves the business's cash flow by delaying expenses.
- Common Mistake to Avoid: Not paying within the agreed period can damage the business's reputation and lead to suppliers demanding cash upfront in the future.
B. Long-Term Finance (Needed for 1 year or more)
Long-term finance is typically used for major investments, such as buying buildings, expensive machinery, or funding large-scale expansion.
1. Bank Loans and Mortgages
Definition: A fixed amount of money borrowed from a bank, paid back over an agreed period (often 1–10 years for a loan, or 25+ years for a mortgage).
- Loans are good for known, specific large expenditures.
- Interest rates are usually lower than an overdraft.
- The bank may require collateral (an asset like property) as security. If the business defaults (stops paying), the bank takes the collateral.
- A Mortgage is simply a specific type of long-term loan used solely to buy property or land.
2. Hire Purchase (HP) and Leasing
These two methods are used for acquiring expensive assets like equipment or vehicles.
Hire Purchase (HP)
Definition: The business pays for an asset (e.g., a delivery van) in installments. The business uses the asset immediately, but only owns it legally after the very last payment is made.
Leasing
Definition: The business effectively rents the asset (e.g., machinery) from the owner (the leasing company) by paying a monthly fee. The business never owns the asset.
- Advantage of Leasing: The leasing company often covers maintenance and repairs, and the business avoids the risk of the asset becoming outdated (obsolete).
3. Debt Factoring
Definition: This is when a business sells its outstanding invoices (money owed to them by customers) to a specialist company (the factor) for immediate cash.
- The business gets cash quickly (e.g., 80% of the invoice value immediately).
- The factor chases the customers for the full payment and keeps the difference as their fee.
- Benefit: Greatly improves cash flow, especially if customers take a long time to pay.
- Cost: The business sacrifices a portion of the revenue (the factor’s fee).
4. Share Capital (Equity Finance)
Definition: Money raised by selling shares (small units of ownership) in the company to investors.
- This is known as equity finance (selling ownership), not debt (borrowing).
- The funds do not have to be repaid, but shareholders gain voting rights and expect a share of the profits (dividends).
- Crucial Distinction: Only incorporated companies (Private Limited Companies – LTDs, and Public Limited Companies – PLCs) can raise money this way. Sole Traders and Partnerships cannot sell shares. PLCs can sell shares to the public on the stock market.
5. Venture Capital
Definition: Money provided by experienced investors (venture capitalists) to businesses that are usually new, innovative, and considered high-risk, but have huge potential for rapid growth.
- The venture capitalist takes a large share of ownership in exchange for the money and often provides management expertise.
- This is a major source of funding for technology start-ups.
6. Grants and Subsidies
Definition: Funds given to a business by the government or other organisations (like the EU or charities) for specific purposes (e.g., creating jobs in a specific area, or developing green technology).
- HUGE Advantage: They do not have to be repaid.
- Disadvantage: Often difficult to obtain, as there is usually fierce competition and strict criteria to meet.
Key Takeaway for External Finance: External sources provide larger amounts of money but come at a cost—either interest (debt) or a loss of ownership (equity).
Section 4: Choosing the Right Source (Matching the Need)
The most important skill in business finance is matching the type of money needed to the source of finance. Using a short-term source for a long-term need is a recipe for disaster!
The Golden Rule of Finance
The term (length of time) of the finance must match the term of the asset or need it is funding.
| If the need is... | The best source is... | Why? |
|---|---|---|
| Buying a new building (Long-term asset) | Mortgage, Long-term Loan, Share Capital | Repayments can be spread over many years, matching the asset's life. |
| A temporary cash flow gap (Short-term need) | Overdraft, Trade Credit, Debt Factoring | Quick fixes that are repaid as soon as the cash flow improves. |
| A sudden, urgent equipment repair (Medium-term need) | Bank Loan or Hire Purchase | Allows repayment over 1–3 years, spreading the cost. |
Factors Influencing the Choice of Finance
When a manager chooses a source, they will consider:
- Purpose: Is it for a new machine (long-term) or paying bills (short-term)?
- Size/Amount Required: Is the business a Sole Trader needing £5,000 or a PLC needing £5 million?
- Risk/Cost: How much interest will be paid? Will the owner lose control?
- Legal Status: Can the business sell shares (LTD/PLC) or not (Sole Trader/Partnership)?
Final Encouragement!
You’ve covered all the core sources of finance! Remember that classifying sources as Internal/External and Short-Term/Long-Term is the key to mastering this chapter. Keep practicing those definitions and you'll be set for success!