Sources of finance

Business AS · Finance and accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Finance is either internal, from inside the business, or external, from people and organisations outside it. Internal finance has no interest and keeps control with the owners, but the amount is limited. External finance can be much larger, but it brings interest, repayments or a share of ownership for others.

The form of ownership limits the choice. Sole traders and partnerships cannot sell shares. A private limited company can sell shares only privately. A public limited company can sell shares to the public on a stock exchange.

The best source depends on cost, flexibility, the wish to keep control, how much debt the firm already has, and the use. Match the length of the finance to the life of what it pays for.

Rules to remember

Internal: owners' investment, retained earnings, sale of unwanted assets, sale and leaseback, cutting working capital (less inventory, faster collection of receivables).
Short-term external: bank overdraft, trade credit, debt factoring (selling unpaid invoices to a factor for immediate cash, less a fee).
Long-term loans: bank loan, mortgage (secured on property), debentures (long-term loan certificates issued by a company, paying fixed interest).
Equity: share capital, new partners, venture capital (funds for risky young firms in return for a share of ownership). No interest and no repayment, but control is diluted.
Leasing = paying to use an asset that the firm never owns. Hire purchase = paying in instalments and owning the asset after the last payment.
Micro-finance = very small loans to people who cannot get normal bank loans. Crowd funding = small amounts from many people, usually online. Government grants normally do not have to be repaid.
A firm that already has high debt should avoid more loans: interest must be paid whatever the profit.

Common mistake

Students suggest an overdraft for buying a long-life asset. An overdraft is for short-term cash shortages; it is expensive over a long period and the bank can ask for repayment at any time.

Worked example

A private limited company has $400,000 of retained earnings and needs $150,000 for new equipment. The owners want no interest charges and no new shareholders. Which source fits best?

No interest rules out bank loans, debentures and hire purchase.
No new shareholders rules out issuing shares and venture capital.
Retained earnings are large enough (400,000 is more than 150,000), cost no interest and leave ownership unchanged.
The drawback is that this profit cannot then be paid out as dividends or used for anything else.

Answer: Retained earnings, an internal source.

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