5.2 Sources of finance

• Why do businesses need finance ?


  • Short-term
  • Long-term
  • Start-up
  • Growth
• Short-term finance needs :


  • Day-to-day costs
  • e.g. paying for utilities, suppliers and employee wages
  • Marketing costs and recruitment costs
• Long-term finance needs :


  • Purchase of non-current assets (e.g. land, property)
  • These are likely to be large sums that may be required for a significant period of time
  • Purchases where retained profit is not sufficient, businesses may consider taking out long-term loans, mortgages or raising share capital
• Start-up finance needs :


  • Needed by a new business to pay for non-current assets (e.g. vehicles, property) and current assets (e.g. stock) before it can begin trading
  • Some small new business owners obtain a start-up loan to cover initial costs
• Financing business expansion :

  • As a business grows, more finance may be needed to purchase capital equipment (e.g. machinery, buildings, vehicles) which help the business increase output
  • If a business wants to grow by developing new products, large amounts may need to be invested in research and development (R&D)
• DISADVANTAGES of internal sources of finance :


  • Significant opportunity cost 
  • (e.g. once retained profit has been used, it is not available for other purposes)
  • May not be sufficient to meet the needs of the business
  • Using an internal finance method is rarely as tax-efficient as many external methods
  • (e.g. loan repayments may be treated as a business cost and offset against tax)
• ADVANTAGES of internal sources of finance :


  • Often free (No interest payment or charges)
  • It does not involve third parties who may want to influence business decisions
  • Can often be organised quickly and without significant paperwork
  • Doesn't require credit checks or collateral
  • (e.g. a bank may request for your house to be pledged as security for a loan)
• Internal Sources of Finance :


  • Owner's Capital (Sole trader)
  • Money saved up by a businesses owner and invested into their own enterprise
  • Retained Profit (Established businesses)
  • Profit made in previous years that is available to reinvest in a business
  • Sale of Assets
  • Money from the sale of equipment, vehicles, land, buildings or reduced-price inventory
  • New Partner (Partnership)
  • Bringing in a new partner to allow them to invest into the business
• External Sources of Finance :




  • Overdraft
  • A short-term flexible arrangement with a bank to allow a business to spend more than it has in its account
  • ADVANTAGE :
  • Extremely flexible
  • DISADVANTAGE :
  • Banks may request repayment whenever they want
• External Sources of Finance :



  • Trade Credit
  • An agreement with a supplier to receive goods now and pay for them at a later date
  • ADVANTAGE :
  • Buyer can sell the products before paying for them
  • DISADVANTAGE :
  • Supplier may not want to sell to you
• External Sources of Finance :



  • Share Issue (PLC)
  • Money raised from the sale of shares
  • ADVANTAGE :
  • No interest
  • DISADVANTAGE :
  • Share ownership
• External Sources of Finance :



  • Loan
  • A long-term arrangement to borrow money from a bank and repay it (with interest) over a determined period of time
  • ADVANTAGE :
  • Long-term, can help with start-up costs
  • DISADVANTAGE :
  • May have high interest rates
• External Sources of Finance :



  • Crowdfunding
  • Asking the public to invest
  • ADVANTAGE :
  • Advert for the business
  • DISADVANTAGE :
  • May not attract any investors
• Factors affecting suitable choice of finance :


  • Timescale
  • How much is needed
  • Purpose of the finance
  • Legal structure
  • Influence of control
  • Level of existing debt
• Factors Affecting the Choice of Finance


  • Timescale :
  • Overdrafts are a short term option to help a firm that needs a smaller amount of finance urgently
  • Mortgages can be paid back over many years
• Factors Affecting the Choice of Finance


  • How much is needed :
  • Large amounts of capital can be raised through the issue of shares to family and friends, or through a flotation on a stock exchange
  • Smaller sums may be accessed through business credit cards or overdrafts
• Factors Affecting the Choice of Finance


  • Purpose of the finance :
  • Fixed assets are most likely to need a long-term source of finance, such as a bank loan
  • A short-term overdraft could cover day-to-day costs such as rent and wages
• Factors Affecting the Choice of Finance


  • Legal structure :
  • Businesses which are already Public Limited Companies can issue shares or debentures
  • Sole traders often rely on owners' capital
• Factors Affecting the Choice of Finance


  • Influence of control :
  • If limited companies issue too many shares, the current owners may lose some control of the business
  • Borrowing retains control, though interest is payable
• Factors Affecting the Choice of Finance


  • Level of existing debt :
  • Businesses with existing loans may have high gearing and pay high rates of interest as they are seen as risky
  • Leasing involves little risk as assets can be returned if finance costs are not paid