5.1.2 The main sources of finance - Advantages and Disadvantages

This section explores the primary ways businesses obtain the funds they need to operate and grow. We will examine both internal and external sources of finance, analyzing their respective advantages and disadvantages.

Internal Sources of Finance

Internal sources of finance come from within the business itself. They do not involve borrowing from outside parties.

Retained Earnings

Retained earnings are the profits a business has made over time that have not been distributed to owners as dividends.

• Advantages:
• Cost-effective - no interest payments.
• Readily available.
• Demonstrates profitability and financial stability.

• Disadvantages:
• May limit the amount available for investment if profits are low.
• Could be more profitable to distribute profits to owners.

Depreciation

Depreciation is the gradual decrease in the value of assets over time due to wear and tear. This is an internal source of finance as it represents a reinvestment of past profits.

• Advantages:
• No direct cost to the business.
• Represents a reinvestment in the business.

• Disadvantages:
• The amount available may be limited by the rate of depreciation.
• Doesn't represent new capital investment.

Sale of Assets

Selling off assets that are no longer needed or are surplus to requirements can generate funds.

• Advantages:
• Provides a quick source of cash.
• Can generate funds from underutilized assets.

• Disadvantages:
• May reduce the business's capacity to generate future income.
• Could be difficult to sell assets at a good price.

External Sources of Finance

External sources of finance involve obtaining funds from outside the business, such as lenders or investors.

Bank Loans

Bank loans are borrowed funds that the business must repay with interest over a specified period.

Advantages	Disadvantages
Relatively easy to access for established businesses.	Interest charges increase the cost of finance.
Can be tailored to specific business needs.	Repayment schedules can be restrictive.
Allows for growth and investment.	Requires collateral (assets) in many cases.

Share Capital

Share capital is money raised by selling shares in the business to investors.

• Advantages:
• No repayment required.
• Provides capital for growth without increasing financial risk.
• Can improve the business's creditworthiness.

• Disadvantages:
• Dilution of ownership for existing shareholders.
• Dividends may have to be paid to shareholders.
• Can be time-consuming and costly to raise.

Debentures

Debentures are a type of loan capital where the business promises to pay a fixed interest rate to the debenture holders and repay the principal amount at a specified future date.

• Advantages:
• Lower interest rates than bank loans.
• Less restrictive repayment terms than bank loans.

• Disadvantages:
• Requires payment of interest, regardless of profitability.
• Creates a liability on the balance sheet.

Mortgages

Mortgages are loans secured against property. Businesses use mortgages to finance the purchase of buildings or land.

• Advantages:
• Allows businesses to acquire valuable assets.
• Interest rates are often tax-deductible.

• Disadvantages:
• The business risks losing the property if the loan cannot be repaid.
• Can be difficult to obtain.

Trade Credit

Trade credit is credit extended by suppliers to customers, allowing them to pay for goods or services at a later date.

• Advantages:
• Provides a flexible source of finance.
• No interest charges if paid within the credit period.

• Disadvantages:
• Can be expensive if not managed carefully.
• May damage relationships with suppliers if not paid on time.

Summary Table

Source of Finance	Type	Advantages	Disadvantages
Retained Earnings	Internal	Cost-effective, readily available	May limit investment, could be more profitable to distribute
Depreciation	Internal	No direct cost, reinvestment	Limited by depreciation rate, doesn't represent new investment
Sale of Assets	Internal	Quick cash, utilizes underutilized assets	Reduces future income capacity, difficult to sell
Bank Loans	External	Easy access (established), tailored	Interest charges, restrictive repayment
Share Capital	External	No repayment, no financial risk	Dilution of ownership, dividend payments, costly to raise
Debentures	External	Lower interest, less restrictive terms	Interest payment regardless of profit, creates liability
Mortgages	External	Acquire valuable assets, tax-deductible interest	Risk of losing property, difficult to obtain
Trade Credit	External	Flexible, no interest if paid on time	Expensive if not managed, damages supplier relationships