3.

2 - Sources of Finance
Why study this?
- We have studied how businesses make a profit: If their revenue is higher than their costs.
- But we need to understand how businesses pay their costs before they generate revenue.

The Supply Chain:

- Products flow from the supplier, to the business, to the customer.
- But which way does the cash flow?
- The business needs to buy raw materials from suppliers before selling products.

Credit:
- The ability to purchase goods and services and agree to make payments for them at a later
date.
- Businesses can acquire raw materials from the supplier without cash by making a credit
agreement.
- Synonyms: finance, debt, borrow.
- Credit is like borrowing something now with a promise to give it back later. It's when
someone trusts you to pay for something after you've already used it. For example,
if you buy something with a credit card, you're using the bank's money to make the
purchase, and then you pay them back later.

Types of Finance:
- Internal Finance:
- Cash that comes from inside the business.
- Sources of internal finance are:
- Personal funds (sole traders):
- The entrepreneur invests their own cash into the business.
- Advantage:
- This will not increase the costs for the business as the cash
will not need to be paid back.
- Disadvantage:
- The entrepreneur can lose their investment.
- Retained profits:
- When the business reinvests its profit into the business.
- Advantage:
- This will not increase the costs for the business and the cash
does not need to be paid back.
- Disadvantage:
- The business loses its safety net and cannot pay its
shareholders dividends for their profit.
- Selling assets:
 - When the business sells its possessions to raise cash to fund an
investment.
- Ex: Selling old machinery to purchase a new van.
- Advantage:
- The business can get cash from unused assets.
- Disadvantage:
- The business may need to buy back these assets in the
future, costing them more.

Activity: Internal Finance, when is it suitable?

Match up the scenario with the suitable source of finance – Write one sentence to explain why:

- A law partnership with a turnover of $400,000 and an old office full of equipment and
furniture, wants to invest in a new, modern office and an online platform for its clients
costing approximately $200,000.
- Suitable Source of Finance: Retained Profit
- Explanation: Retained profit would be suitable as the law partnership can use its
accumulated profits to fund the investment in the new office and online platform
without needing external financing.

- A sole trader who owns a successful hair salon wants to diversify into hair and beauty. To do
this, she will need to convert part of her salon into a beauty studio.
- Suitable Source of Finance: Personal Funds
- Explanation: Using personal funds would be suitable as the sole trader can invest her
own money into the salon's expansion, avoiding debt or external financing.

- Airline PLC wants to invest in offering flights to a new, long-distance destination. To do this,
it is planning on removing some flights from short-distance destinations.
- Suitable Source of Finance: Selling Assets
- Explanation: Selling assets would be suitable as the airline can generate funds by
selling off assets such as aircraft used for short-distance flights to finance the
investment in flights to the new long-distance destination.

External Finance:
- Cash that comes from outside the business.
- Sources of external finance are:
- Overdraft: Short-term
- An overdraft can be added to most personal and business bank accounts.
- An overdraft is when the bank allows the account holder to use their
account even if there are no funds available.
- This allows the user to borrow cash at short notice, as it is pre-arranged.
- The user must then pay interest on the amount borrowed.
- This is usually very high at approximately 40%.
- Trade Credit: Short-term
- Trade Credit is an agreement between a business and its supplier.
 - The business can ‘purchase’ supplies when they are needed for the business
and pay the cost later when they have the cash available.
- The agreements are prearranged and have several restrictions, such as a
credit limit and a maximum credit period.
- The supplier will usually offer retrospective discounts to the business to
reward them for their brand loyalty.
- Loan Capital: Long-term
- A loan is an amount of money lent to an individual or business that will be
paid off with interest over an agreed period of time.
- The interest rate on a long-term loan is likely to be fixed, meaning that the
rate will not change.
- The bank will undertake a credit check on an individual or business when
agreeing on a loan with them.
- The bank may also demand security from the business in the form of assets.
- If the business cannot pay back the loan, the security can be used in order to
settle the debt. (Such as a property).
- Share Capital: Long-term
- Share capital can be raised if a business decides to sell a part (a share) of its
business.
- Large amounts of capital can be raised.
- A shareholder who buys this share becomes a part owner of the business
and therefore has an input into the decisions that are being made.
- LTDs can only sell shares to those known privately whereas PLCs can sell
shares to the public via the stock exchange.
- Businesses that sell more than 51% of shares risk suffering from a hostile
takeover – where control is lost.
- Crowd Funding: Long-term
- Crowdfunding means that a business obtains funding from a large number
of people who each pay a small amount of cash to the business.
- Crowdfunding websites such as Kick-starter enable people to invest in a
business by paying just a small amount of cash.
- If a large number of people invest a small amount of cash into the same
business, it can raise enough capital for the business to make a large
purchase.
- If an individual is willing to invest into a business, they are also likely to be
brand loyal to that business, increasing sales revenue.
- It is difficult for businesses to raise funds in a short time period, and this
type of finance is more suited for large investments such as opening a new
- store.
- Leasing: Short-term or Long-term
- Leasing is when a lessee borrows equipment or property from a lessor for an
agreed fee per period of time.
- This means that the business doesn’t need to invest in capital expenditure,
but this can increase revenue expenditure.
 - This can be used both in the short term or long term, but if using it long-
term, the cost can end up higher.
- The maintenance of the equipment is the lessor’s responsibility, so this can
reduce costs to some extent.
- Microfinance Providers: Long-Term
- Set up with the aim to support people without an income or job, set up their
small enterprise.
- These companies help people by allowing them to borrow small amounts of
money, ex: $80 to purchase some basic equipment to start offering a
service.
- Entrepreneurs can get into large debt if it is unsuccessful.
- It is contested whether this practice is supportive of low-income
communities, or unethical as it is profiting from the interest of poorer
entrepreneurs.
- Business Angels: Long-term
- Business angels are wealthy investors, who put money into a business in the hope
for a return on their investment through equity or an agreed % of profit at the end
of a project.
- Often, business angels come from Private Equity Firms.
- It is a high risk for the business angel, but the business does benefit from long-term
guidance from experienced firms/entrepreneurs.
- Think Dragon’s Den or Shark Tank.

Factors affecting the choice of finance:

- S – Size of organisation:
- Why are microfinance providers not suitable for large businesses?
- P – Purpose of finance:
- Why is an overdraft not suitable for new machinery?
- A – Amount Required:
- Why is selling assets not suitable for large sums of finance?
- C – Costs:
- Why would a company want to avoid a loan?
- E – External Influences:
- How might interest rates affect business decisions?
- D – Duration Required:
- Why is crowdfunding not suitable for finance needed to cover revenue expenditure?

Exam Technique: Appropriateness of Finance

A typical examination question is:
Discuss two appropriate sources of finance for Company X to purchase… (capital goods).
Capital goods: Physical assets a company uses to produce goods and services for consumers. Ex:
tools, machinery, buildings, equipment, vehicles.

To answer such a question, students need to ensure the sources of finance in their response are
appropriate for the business in the case study.
For example:
- Issuing shares would not be appropriate for a sole trader, partnership, or even a privately
held company.
- Overdrafts and other forms of short-term finance would not be suitable for purchasing
capital assets such as a fleet of new motor vehicles or for financing investment decisions.
- Retained profits and the sale of assets would not be suitable as sources of internal finance
for a business start-up or an organisation with liquidity (ease with which an asset can be
converted into cash without significantly affecting its market price) problems.