5.1.2 The Main Sources of Finance

This section explores the various ways a business can obtain the funds it needs to operate and grow. Understanding these sources is crucial for effective financial planning and decision-making. We will examine the advantages and disadvantages of each, and learn how to recommend the most suitable option for a specific business situation.

1. Internal Sources of Finance

These are funds generated from within the business itself. They don't require external investment.

1.1 Retained Earnings

Definition: Profits that the business has made in the past and has not distributed to owners as dividends. These profits are reinvested back into the business.

Advantages:

• No external cost – the money is already available.
• Demonstrates profitability and financial stability.
• Can be used for a variety of purposes – expansion, new equipment, research and development.

Disadvantages:

• May not be sufficient for large investments.
• Requires the business to be profitable. A struggling business may have limited retained earnings.

1.2 Sale of Assets

Definition: Selling non-essential assets, such as old equipment, buildings, or land, to generate funds.

Advantages:

• Quick source of cash.
• Can dispose of assets that are no longer needed or are underperforming.

Disadvantages:

• May reduce the business's capacity to produce goods or services.
• Could be difficult to find a buyer for assets.
• May not generate as much cash as anticipated.

2. External Sources of Finance

These are funds obtained from outside the business, from individuals or institutions.

2.1 Bank Loans

Definition: Borrowing money from a bank, which must be repaid with interest over a specified period.

Advantages:

• Can provide a large sum of money.
• Relatively easy to access for established businesses with good credit history.

Disadvantages:

• Interest charges increase the overall cost of borrowing.
• Requires regular repayments, which can strain cash flow.
• Banks require collateral (assets) as security for the loan.

2.2 Share Capital

Definition: Selling ownership in the business (shares) to investors in exchange for capital.

Advantages:

• Does not need to be repaid.
• Provides capital without increasing financial risk for the business.
• Can bring in expertise and contacts from investors.

Disadvantages:

• Dilutes ownership of the business for existing shareholders.
• Requires the business to share profits with shareholders (dividends).
• Can be time-consuming and expensive to issue shares.

2.3 Directors' Loans

Definition: Money lent to the business by the directors of the company.

Advantages:

• Simple and quick to arrange.
• Interest rates may be lower than bank loans.

Disadvantages:

• Can create conflicts of interest if directors are not properly compensated.
• May be difficult to recover if the business fails.

2.4 Government Grants and Subsidies

Definition: Money provided by the government to support specific types of businesses or projects. Grants are typically not repaid, while subsidies can be either grants or reductions in the cost of production.

Advantages:

• Often interest-free (grants).
• Can help businesses to develop new products or services.
• Reduces the cost of production (subsidies).

Disadvantages:

• Can be difficult to obtain – often requires a detailed application process.
• May be subject to strict conditions and reporting requirements.

2.5 Leasing

Definition: Paying for the use of an asset (e.g., equipment, vehicles) rather than buying it outright. Involves regular payments over a set period.

Advantages:

• Lower initial cost compared to buying.
• Allows access to up-to-date equipment.
• Can improve cash flow.

Disadvantages:

• Total cost of leasing can be higher than buying.
• Does not build ownership of the asset.

3. Choosing the Right Source of Finance

The best source of finance depends on the specific circumstances of the business. Consider the following factors:

• Amount of money needed: Large amounts may require bank loans or share capital.
• Time required: Retained earnings are the quickest. Share capital can take time to raise.
• Risk involved: Retained earnings and bank loans are generally lower risk.
• Control of the business: Share capital dilutes ownership.
• Cost of finance: Consider interest rates on loans versus the cost of dividends on shares.
• Stage of business: Start-ups may rely on personal savings or loans from friends and family. Established businesses may have access to a wider range of options.

Example Scenario: A small bakery needs £10,000 to purchase a new oven. The owner has £2,000 in retained earnings. They could:

1. Use the retained earnings and save £8,000.
2. Take out a bank loan for £10,000.
3. Issue shares to investors for £10,000.
4. Lease the oven.

The best option depends on the bakery's financial situation and risk tolerance. If the bakery is confident in its future profitability, taking out a bank loan might be a good option. If the bakery is unsure, seeking investment through shares might be more appropriate.

Table summarizing the sources of finance:

Source of Finance	Advantages	Disadvantages
Retained Earnings	No external cost, demonstrates profitability	May not be sufficient, requires profitability
Sale of Assets	Quick cash, disposes of underperforming assets	Reduces production capacity, may be difficult to sell
Bank Loans	Large sums, relatively easy access	Interest charges, requires repayments, collateral required
Share Capital	No repayment, brings in expertise	Dilutes ownership, requires dividend payments, can be expensive
Directors' Loans	Simple, quick, potentially lower interest	Conflicts of interest, difficult to recover
Government Grants/Subsidies	Interest-free (grants), supports development	Difficult to obtain, strict conditions
Leasing	Lower initial cost, access to up-to-date equipment	Higher total cost, no ownership