Key definitions
- Internal source of finance — finance that is sourced from within the business, e.g. owner's savings and retained profit.
- External source of finance — finance that is sourced from outside the business, e.g. bank loans.
- Trade payable — money owed by a business to a third party for purchasing on credit (e.g. a trade payable to suppliers).
- Trade receivable — money owed to a business from a third party who purchased on credit.
Why do businesses need finance?
- To pay for day-to-day expenses to run the business, e.g. inventory (working capital).
- To purchase non-current assets (capital expenditure).
- To pay for expansion, such as developing new products and opening new shops.
- To be able to pay to set up the business when first starting (start-up capital).
Short-term vs long-term finance needs
| Short-term finance | Long-term finance |
|---|
| Used to pay wages, rent and needs that must be paid for often (to improve a business' cash flow for the time being). | Used to fund purchases often used for more than 1 year (e.g. machinery or finance to expand the business). |
Factors considered in making a financial choice
- Size and form of business — e.g. owner's savings may not be enough for a public limited business.
- Amount required — e.g. microfinancing would not be enough if a large amount is needed.
- Length of time the finance is needed for.
- Existing loans — unpaid existing loans may reduce a firm's trustworthiness (credit history); banks may be unwilling to lend them more finance.
- Cost of finance — how much is the associated interest or dividend payment?
Sources of finance
Owner's savings
The business owner's personal money that they are willing to invest into the business.
- Type of finance: long-term / short-term
| Advantages | Disadvantages |
|---|
| No interest or debts owed. It is instant finance. | May not be enough to fund large expansions. |
Retained profit
The profit kept in the business after tax and dividends are paid.
- Type of finance: long-term / short-term
| Advantages | Disadvantages |
|---|
| No interest or debts owed. | May not be enough, and using this would also take away some of the owner's profits. |
Bank loan
A sum of money borrowed from a bank that must be paid back.
- Type of finance: long-term / short-term
| Advantages | Disadvantages |
|---|
| It is a source of instant finance, and large businesses can benefit from economies of scale. | The money has to be paid back, and interest must also be paid regularly. |
Trade credit
The delaying of payment to suppliers to improve the cash position of a business.
- Type of finance: short-term
| Advantages | Disadvantages |
|---|
| It does not require interest or debts. | A supplier may no longer want to supply to the business due to the risk of payments not being made subsequently. |
Overdraft
When a bank allows a business to spend over what is in their bank account.
- Type of finance: short-term
| Advantages | Disadvantages |
|---|
| It is cheaper than a loan. | The money has to be paid back as well as interest. The bank can ask for the money to be paid back suddenly. |
Micro-finance
Organisations provide finance to small businesses, usually in less developed areas.
- Type of finance: short-term
| Advantages | Disadvantages |
|---|
| It could be an alternative for businesses who cannot get approval from the bank for a loan. | Interest may have to be paid and the money will need to be paid back at intervals. |
Debt factoring
Where a business hires specialised debt collectors to collect debts owed to the business by customers who have paid by credit.
- Type of finance: short-term
| Advantages | Disadvantages |
|---|
| Instant finance is provided. | The specialists take some of the money as their pay, so the full amount is not paid back. |
Leasing
Where a business pays sums of money to use assets such as machinery without purchasing them.
- Type of finance: long-term
| Advantages | Disadvantages |
|---|
| It is cheaper than purchasing the asset itself. | Over time, the total of the payments from leasing could amount to over the cost of the asset. |
Crowdfunding
Where a business collects money from the general public and their donations.
- Type of finance: short-term
| Advantages | Disadvantages |
|---|
| It does not involve debts and paying back. | It is not a reliable source of finance as it is slow and the goal may not be met. |
Issue of shares
This is applicable for limited organisations who can sell shares to the public for capital.
- Type of finance: long-term
| Advantages | Disadvantages |
|---|
| Instant finance and no debts involved. | There is less control over the business as more percentage ownership is lost. |