Unit 3: Finance and Accounts
3.2 - Sources of Finance
Understanding Internal, External, Short-Term, and Long-Term Funding Options
Introduction: Why Businesses Need Finance
Finance is the lifeblood of any business. Organizations need money for various purposes at different stages of their lifecycle.
Common reasons businesses need finance:
- Start-up capital: Initial investment to establish the business
- Working capital: Day-to-day operational expenses (wages, rent, utilities)
- Expansion and growth: Opening new locations, entering new markets
- Fixed assets: Purchasing equipment, machinery, buildings
- Research and development: Developing new products or technologies
- Marketing campaigns: Promoting products and building brand
- Cash flow management: Covering temporary shortfalls
- Acquisitions: Buying other businesses
Classification of Finance Sources
Sources of finance can be classified in two main ways:
1. By Origin:
- Internal sources: Finance generated from within the business
- External sources: Finance obtained from outside the business
2. By Duration:
- Short-term finance: Repayable within one year
- Long-term finance: Repayable over more than one year
1. Internal Sources of Finance
Internal finance refers to money generated from within the business's own operations, without involving external parties.
Key advantage: No interest payments or loss of ownership
A. Retained Profit
Definition: Profit kept by the business rather than distributed to owners/shareholders as dividends.
Formula:
\[ \text{Retained Profit} = \text{Net Profit} - \text{Dividends Paid} \]How it works:
- Business earns profit from operations
- After paying taxes, management decides dividend amount
- Remaining profit retained for reinvestment
- Accumulates over years in reserves
Uses:
- Finance expansion projects
- Purchase new equipment
- Develop new products
- Build financial cushion for emergencies
Advantages of Retained Profit
- No cost: No interest payments or fees
- No ownership dilution: Owners maintain full control
- No debt: Doesn't increase liabilities
- Flexible: Can be used for any purpose
- Permanent capital: No repayment required
- Shows financial strength: Demonstrates profitability to investors
Disadvantages of Retained Profit
- Limited amount: Only available if business is profitable
- Opportunity cost: Shareholders miss out on dividends
- May disappoint shareholders: Investors want returns
- Not suitable for start-ups: No profit history
- Takes time to accumulate: Slow source for large projects
B. Sale of Assets
Definition: Selling assets the business owns to raise cash.
Types of assets that can be sold:
- Fixed assets: Buildings, land, machinery, vehicles
- Inventory: Excess or obsolete stock
- Investments: Shares in other companies
- Intellectual property: Patents, trademarks
Sale and leaseback:
- Business sells asset (e.g., building) to buyer
- Immediately leases it back to continue using it
- Raises cash while maintaining operational use
Advantages of Sale of Assets
- Quick cash: Immediate liquidity
- No debt: Doesn't create liabilities
- No interest: No ongoing costs
- Removes unused assets: Eliminates maintenance costs
- Improves efficiency: Forces focus on core assets
Disadvantages of Sale of Assets
- Loss of asset: No longer own valuable resources
- May need replacement: Future costs to acquire again
- Reduced capacity: Less ability to produce/operate
- One-time source: Can't be repeated
- May signal distress: Market may view negatively
- Below market value: Urgent sales may get lower price
C. Reduction of Working Capital
Definition: Managing current assets and liabilities more efficiently to free up cash.
Working Capital Formula:
\[ \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities} \]Methods to reduce working capital requirements:
1. Reduce Inventory (Stock):
- Just-in-time (JIT) inventory management
- Sell off slow-moving or excess stock
- Better demand forecasting
- Frees up cash tied up in unsold goods
2. Reduce Debtors (Receivables):
- Tighter credit control
- Offer early payment discounts
- Faster invoicing and follow-up
- Factoring (selling debts to third party)
3. Increase Creditors (Payables):
- Negotiate longer payment terms with suppliers
- Delay payments (within agreed terms)
- Use supplier credit more effectively
Advantages of Reducing Working Capital
- No cost: Internal efficiency improvement
- Improves cash flow: More cash available
- Better management: More efficient operations
- Ongoing benefit: Continuous improvement
Disadvantages of Reducing Working Capital
- Risk of stockouts: Too little inventory may lose sales
- Customer dissatisfaction: Strict credit terms may upset customers
- Supplier relationships: Delaying payments may damage relations
- Limited amount: Can only reduce so much
- Operational risk: Too lean may cause problems
D. Personal Funds (Owner's Capital)
Definition: Money invested by the owner(s) from their personal savings.
Common for:
- Start-ups and small businesses
- Sole traders and partnerships
- When external finance unavailable
Advantages
- No interest or repayment required
- Full control maintained
- Quick and easy to access
- Shows commitment to investors
Disadvantages
- Limited by owner's wealth
- Personal financial risk
- Opportunity cost (can't invest elsewhere)
- May not be sufficient for large needs
2. External Sources of Finance
External finance refers to money obtained from outside the business from various stakeholders and institutions.
Two main categories:
- Equity finance: Selling ownership shares
- Debt finance: Borrowing money to be repaid
A. Share Capital (Equity Finance)
Definition: Finance raised by selling shares (ownership stakes) in the company to investors.
Types of shares:
1. Ordinary Shares (Common Stock):
- Basic ownership with voting rights
- Dividends paid from profits (not guaranteed)
- Shareholders share in company's success
- Last to be paid if company liquidates
2. Preference Shares:
- Fixed dividend rate (paid before ordinary shareholders)
- Usually no voting rights
- Priority in liquidation (after creditors)
- More secure but less upside potential
Where shares are issued:
- Private companies: Shares sold privately to known investors
- Public companies: Shares traded on stock exchange
Advantages of Share Capital
- No repayment: Permanent capital, never needs to be repaid
- No interest: No mandatory payments (dividends discretionary)
- No collateral: No assets needed as security
- Large amounts: Can raise substantial funds (especially public companies)
- Shares risk: Shareholders share business risk
- Improved credibility: More shareholders shows confidence
Disadvantages of Share Capital
- Dilution of ownership: Existing owners' control reduced
- Dilution of profit: Profits shared among more shareholders
- Loss of control: New shareholders may influence decisions
- Dividend expectations: Pressure to pay dividends
- Complex and expensive: Legal costs, stock exchange fees (for IPO)
- Disclosure requirements: Must publish financial information
- Not available to all: Only limited companies can issue shares
B. Loan Capital (Debt Finance)
Definition: Money borrowed from lenders that must be repaid with interest.
Types of loans:
1. Bank Loans:
- Fixed amount borrowed for specific period
- Repaid in regular installments (monthly/quarterly)
- Interest charged on outstanding balance
- Usually requires collateral (security)
- Fixed or variable interest rate
Interest Formula:
\[ \text{Simple Interest} = \text{Principal} \times \text{Rate} \times \text{Time} \] \[ \text{Total Repayment} = \text{Principal} + \text{Interest} \]2. Debentures (Bonds):
- Long-term debt securities issued by company
- Investors lend money to company
- Fixed interest rate (coupon rate) paid regularly
- Principal repaid at maturity date
- Can be traded on bond market
3. Mortgages:
- Long-term loans for purchasing property
- Property serves as collateral
- Typically 15-30 year repayment period
Advantages of Loan Capital
- No ownership dilution: Owners maintain full control
- Tax deductible: Interest payments reduce taxable profit
- Large amounts: Can borrow substantial sums
- Builds credit history: Successful repayment improves credit rating
- Predictable costs: Fixed repayment schedule
Disadvantages of Loan Capital
- Interest costs: Expensive over time
- Mandatory repayment: Must repay regardless of profit
- Collateral risk: May lose assets if can't repay
- Affects credit rating: High debt reduces creditworthiness
- Cash flow pressure: Regular payments strain liquidity
- Restrictions: Loan covenants may limit business decisions
- Not always available: May not qualify if risky
C. Overdraft
Definition: Flexible borrowing arrangement allowing business to withdraw more money than available in bank account, up to agreed limit.
How it works:
- Bank agrees overdraft limit (e.g., $10,000)
- Business can go into negative balance up to limit
- Interest charged only on amount overdrawn
- Repayable on demand
Example calculation:
Bank balance: -$5,000 (overdrawn)
Overdraft rate: 8% per annum
\[ \text{Daily interest} = \frac{5000 \times 0.08}{365} = \$1.10 \text{ per day} \]Advantages of Overdraft
- Flexible: Use only when needed
- Quick access: Immediate availability
- Interest only on usage: Pay only for what you use
- Helps cash flow: Covers temporary shortfalls
- Easy to arrange: Simpler than formal loan
Disadvantages of Overdraft
- High interest rates: Usually higher than loans
- Repayable on demand: Bank can withdraw facility anytime
- Limited amount: Typically small overdraft limits
- Fees and charges: Additional costs beyond interest
- Encourages overspending: Easy access may lead to overuse
D. Trade Credit
Definition: Credit period offered by suppliers, allowing business to receive goods now but pay later.
How it works:
- Supplier delivers goods/services
- Invoice issued with payment terms (e.g., "Net 30" = pay within 30 days)
- Business uses goods before payment due
- Common terms: 30, 60, or 90 days
Early payment discounts:
Terms like "2/10 Net 30" mean:
- 2% discount if paid within 10 days
- Otherwise full payment due in 30 days
Advantages of Trade Credit
- Interest-free: No interest charged (if paid on time)
- Easy to obtain: Automatic with many suppliers
- Improves cash flow: Delay payment while using goods
- Flexible: Negotiable terms
- No collateral: No assets required as security
Disadvantages of Trade Credit
- Short-term only: Usually 30-90 days maximum
- Limited amount: Depends on order size
- Miss discounts: Lose early payment discounts
- Damages relationships: Late payment harms supplier relations
- May lose credit: Suppliers may refuse future credit
- Penalties: Late payment fees and interest
E. Leasing
Definition: Renting assets (equipment, vehicles, property) for regular payments instead of buying.
Types:
1. Operating Lease:
- Short-term rental
- Lessor maintains and repairs asset
- Can return or upgrade asset
- Example: Leasing office equipment
2. Finance Lease:
- Long-term, similar to buying
- Lessee responsible for maintenance
- Option to purchase at end
- Example: Leasing vehicles for company fleet
Advantages of Leasing
- No large upfront cost: Preserve capital
- Predictable costs: Fixed monthly payments
- Tax benefits: Lease payments often tax deductible
- Up-to-date equipment: Can upgrade regularly
- Maintenance included: (operating lease)
- No disposal hassle: Return at end of term
Disadvantages of Leasing
- Never own asset: No equity built
- Long-term cost higher: Total payments exceed purchase price
- Contractual obligation: Committed to payments
- Penalties: Early termination fees
- Restrictions: Limited use, mileage limits (vehicles)
F. Venture Capital
Definition: Investment in high-risk, high-potential start-ups and growth companies by professional investors.
How it works:
- Venture capital (VC) firms invest in exchange for equity
- Provide expertise and mentorship
- Seek high returns through eventual exit (IPO or acquisition)
- Common in tech, biotech, innovative industries
Advantages
- Large amounts available
- Expertise and guidance from investors
- No repayment if business fails
- Network connections
- Credibility boost
Disadvantages
- Significant ownership dilution
- Loss of control (VCs want board seats)
- Pressure for rapid growth
- Complex negotiations
- Difficult to obtain (highly selective)
G. Business Angels
Definition: Wealthy individuals who invest their own money in start-ups in exchange for equity.
Characteristics:
- Smaller amounts than VCs (typically $25,000-$500,000)
- Often successful entrepreneurs themselves
- Provide mentorship and advice
- Earlier stage than VCs
H. Crowdfunding
Definition: Raising small amounts of money from large number of people, typically via online platforms.
Types:
- Reward-based: Contributors receive product/service (Kickstarter, Indiegogo)
- Equity-based: Contributors receive shares
- Debt-based: Peer-to-peer lending with interest
- Donation-based: No return expected (charity)
I. Government Grants and Subsidies
Definition: Financial support from government that doesn't need to be repaid.
Common types:
- Small business grants
- Research and development funding
- Export assistance
- Green technology subsidies
- Regional development grants (encourage business in specific areas)
Advantages
- Free money (no repayment or interest)
- No ownership dilution
- Supports specific objectives
- Credibility boost
Disadvantages
- Highly competitive
- Strict eligibility criteria
- Time-consuming application
- Conditions and restrictions
- Reporting requirements
- Limited availability
3. Short-Term vs. Long-Term Sources of Finance
Short-Term Finance (Up to 1 Year)
Purpose: Meet immediate, temporary needs
Common short-term sources:
- Overdrafts: Temporary cash flow support
- Trade credit: 30-90 day payment terms
- Short-term loans: Repayable within a year
- Factoring: Selling receivables for immediate cash
- Reducing working capital: Improving cash conversion cycle
Uses:
- Working capital (day-to-day expenses)
- Seasonal fluctuations
- Unexpected emergencies
- Bridge finance (until long-term funding arranged)
Long-Term Finance (Over 1 Year)
Purpose: Fund major investments and strategic initiatives
Common long-term sources:
- Share capital: Permanent capital
- Retained profit: Accumulated over years
- Debentures: Long-term debt securities
- Long-term bank loans: 5-25 year repayment
- Mortgages: Property loans (15-30 years)
- Venture capital: Growth investment
- Leasing: Long-term asset financing
Uses:
- Purchasing fixed assets (buildings, machinery)
- Business expansion and acquisitions
- Research and development projects
- Major capital expenditures
Matching Principle
Finance should match the purpose:
- Short-term needs → Short-term finance: Working capital funded by overdraft, trade credit
- Long-term needs → Long-term finance: Fixed assets funded by shares, long-term loans
Why matching matters:
- Risk management: Avoid repaying loan before asset generates returns
- Cost efficiency: Short-term finance often more expensive for long-term needs
- Cash flow stability: Matches income generation with repayment obligations
Example of mismatch problem:
- ❌ Wrong: Buy factory (30-year asset) with overdraft (repayable on demand)
- ✓ Right: Buy factory with mortgage (25-year loan)
4. Comparison Tables
Internal vs. External Sources
| Aspect | Internal Finance | External Finance |
|---|---|---|
| Source | From within business operations | From outside parties |
| Examples | Retained profit, sale of assets, working capital reduction | Shares, loans, overdrafts, venture capital |
| Cost | No interest or fees | Interest, fees, or ownership dilution |
| Ownership | No dilution | May dilute ownership (shares) |
| Amount | Limited by business resources | Can be substantial |
| Speed | Quick access | May take time (applications, approvals) |
| Availability | Only if business profitable/has assets | Available to wider range of businesses |
Short-Term vs. Long-Term Finance
| Aspect | Short-Term Finance | Long-Term Finance |
|---|---|---|
| Duration | Up to 1 year | Over 1 year (often 5-30 years) |
| Purpose | Working capital, temporary needs | Fixed assets, major investments |
| Examples | Overdraft, trade credit, factoring | Shares, debentures, long-term loans, mortgages |
| Interest Rate | Often higher (higher risk for lender) | Usually lower (secured, longer commitment) |
| Flexibility | More flexible, can be repaid early | Less flexible, fixed terms |
| Risk | Lower commitment risk | Higher commitment, long-term obligation |
Equity vs. Debt Finance
| Aspect | Equity Finance (Shares) | Debt Finance (Loans) |
|---|---|---|
| Nature | Ownership investment | Borrowed money |
| Repayment | Never repaid (permanent capital) | Must be repaid with interest |
| Returns | Dividends (discretionary) | Interest (mandatory) |
| Ownership | Diluted (share control) | No dilution |
| Risk to Business | Shareholders share risk | Full risk on business |
| Tax Treatment | Dividends not tax deductible | Interest tax deductible |
| Cost | Can be expensive long-term (dividends) | Fixed cost (interest rate) |
5. Factors Influencing Choice of Finance
Businesses consider multiple factors when selecting finance sources:
- Amount needed: Small needs may use overdraft; large projects need shares or loans
- Duration: Short-term needs use short-term finance; long-term investments need long-term funding
- Cost: Compare interest rates, fees, opportunity costs
- Control: Owners wanting control avoid issuing shares
- Risk: Risk-averse businesses prefer not borrowing heavily
- Business type: Only limited companies can issue shares; sole traders limited to personal funds and loans
- Business stage: Start-ups use personal funds, angels; established firms use retained profit, shares
- Economic conditions: Low interest rates favor borrowing; bull markets favor share issues
- Availability: Some sources not available to all businesses
- Flexibility: Some businesses prefer flexible options like overdrafts
IB Business Management Exam Tips
Key Definitions
- Internal finance: Money generated from within the business (retained profit, sale of assets)
- External finance: Money obtained from outside parties (shares, loans, venture capital)
- Short-term finance: Funding repayable within one year (overdraft, trade credit)
- Long-term finance: Funding for over one year (shares, debentures, mortgages)
- Equity finance: Selling ownership shares for investment
- Debt finance: Borrowing money to be repaid with interest
Common Exam Questions
- "Distinguish between internal and external sources of finance" (4 marks)
- "Explain two sources of finance suitable for a start-up business" (6 marks)
- "Discuss whether a business should use debt or equity finance for expansion" (10 marks)
- "Evaluate the appropriateness of different sources of finance for [scenario]" (10 marks)
Answer Tips
- Context matters: Always relate to business size, stage, and situation
- Advantages AND disadvantages: Present balanced view
- Use examples: Real or hypothetical scenarios strengthen answers
- Apply concepts: Don't just list—analyze suitability
- Consider alternatives: Compare different options
- Matching principle: Short-term finance for short-term needs
✓ Unit 3.2 Summary: Sources of Finance
You should now understand that businesses need finance for start-up, operations, expansion, and investments. Internal sources (retained profit, sale of assets, working capital reduction, owner's capital) come from within with no cost but are limited in amount. External sources include equity finance (ordinary and preference shares - permanent capital with no repayment but dilutes ownership) and debt finance (loans, debentures, overdrafts - must be repaid with interest but no ownership loss). Other external options include trade credit (interest-free supplier credit), leasing (renting assets), venture capital (investment in high-growth businesses), and government grants (free funding). Finance is classified as short-term (up to 1 year for working capital: overdrafts, trade credit) or long-term (over 1 year for fixed assets: shares, long-term loans, mortgages). The matching principle states that short-term needs should use short-term finance and long-term investments require long-term funding. Choice depends on amount needed, duration, cost, control preferences, risk tolerance, business type/stage, and economic conditions.