Every business requires financial resources to operate, grow, and achieve its objectives. These financial resources, known as sources of finance, can be obtained from various means.
Understanding the different sources of finance is crucial for businesses to make informed decisions about how to fund their operations and expansion plans. Sources of finance can be broadly categorized into internal and external sources.
Internal sources include funds generated within the business, such as retained earnings, personal funds, and the sale of unused assets. External sources involve funds raised from outside the business, such as bank loans, equity financing, and government grants.
Each source of finance comes with its own set of advantages, disadvantages, and implications for the business, making it essential to choose the right mix based on the company's needs and financial strategy.
Internal sources of finance
Internal sources of finance are funds that are generated from within the business. Here are three common internal sources of finance:
Retained Profit:
Retained profit refers to the portion of the net earnings that is not distributed to shareholders as dividends but is kept in the business for reinvestment.
It is a cost-effective source of finance since it does not involve borrowing costs or dilution of ownership. It can be used to finance expansion, invest in new projects, or improve infrastructure. Example: A company decides to use its retained earnings from the previous year to open a new branch.
Sale of Unused Assets:
This involves selling assets that are no longer in use or necessary for the business. These can include old machinery, surplus inventory, or unused property.
It generates immediate cash flow without increasing liabilities. It also helps in optimizing the use of resources by getting rid of unproductive assets. Example: A manufacturing company sells old equipment that is no longer needed due to technological upgrades.
Personal Funds:
In the case of small businesses or startups, personal funds refer to the money that the business owner invests from their own savings.
It shows commitment to the business and does not require repayment or interest, unlike loans. It also avoids ownership dilution, keeping control within the owner’s hands. Example: An entrepreneur uses their personal savings to finance the initial setup costs of their new business venture.
External sources of finance
External sources of finance are funds that a business obtains from outside its operations. Here are brief explanations of six common external sources:
Share Capital:
Share capital is money raised by issuing shares of the company to investors. Shareholders become part-owners of the business and may receive dividends.
Provides significant capital for expansion without the need for repayment. It also spreads the financial risk among a large number of investors. Example: A company issues new shares to the public through a stock exchange.
Loan Capital:
Loan capital is money borrowed from financial institutions like banks, which must be repaid with interest over a set period.
Allows businesses to access large amounts of money for investment. Loan terms can be tailored to suit the business's needs. Example: A business takes out a long-term loan to purchase new manufacturing equipment.
Bank Overdraft:
A bank overdraft allows a business to withdraw more money from its bank account than it currently has, up to an agreed limit.
Provides flexible, short-term financing to cover immediate cash flow needs. Interest is only paid on the amount overdrawn. Example: A company uses an overdraft to pay for unexpected expenses while waiting for customer payments to come in.
Trade Credit:
Trade credit is an arrangement where suppliers allow a business to buy goods or services and pay for them at a later date.
Improves cash flow and allows the business to use goods or services before payment is made, without immediate cash outflow. Example: A retailer receives inventory from a supplier and agrees to pay for it in 30 days.
Crowdfunding:
Crowdfunding involves raising small amounts of money from a large number of people, typically through online platforms.
Provides access to a wide pool of investors and can also serve as a marketing tool. It’s often easier to raise funds for innovative or community-focused projects. Example: A startup raises capital by pitching its idea on a crowdfunding website and attracting contributions from individual backers.
Business Angel:
Business angels are wealthy individuals who invest their personal funds into startups or small businesses in exchange for equity.
Provides not only capital but also valuable expertise, mentorship, and industry connections. Terms can be more flexible than institutional investors. Example: An entrepreneur receives investment from a business angel who also offers guidance on business strategy.
These external sources of finance are essential for businesses to support their growth, manage cash flow, and take advantage of new opportunities.
10 factors that influence the selection of a source of finance
- Cost
- Risk
- Flexibility
- Control
- Time
- Availability
- Creditworthiness
- Purpose of Finance
- Repayment terms
- Impact on financial statement
Multiple Choice Questions
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Question 1: Which of the following is an example of an internal source of finance?
A) Bank loan
B) Issuing new shares
C) Retained profit
D) Government grant
Explanation: Retained profit is an internal source of finance, as it comes from the company's own earnings that are kept within the business instead of being distributed to shareholders.
Question 2: What is the primary advantage of using personal funds as a source of finance?
A) It avoids ownership dilution
B) It generates immediate cash flow from asset sales
C) It requires repayment with interest
D) It involves issuing new equity
Explanation: Using personal funds as a source of finance avoids ownership dilution, as it does not involve bringing in new shareholders or giving up equity in the business.
Question 3: Selling old machinery that is no longer needed in the business is an example of:
A) Retained profit
B) Personal funds
C) Sale of unused assets
D) External financing
Explanation: Selling old machinery that is no longer needed is an example of generating finance through the sale of unused assets.
Question 4: What is share capital?
A) Funds borrowed from a bank
B) Money raised by issuing shares of a company
C) Credit extended by suppliers
D) Money raised through crowdfunding platforms
Explanation: Share capital is the money a company raises by issuing shares of its stock to investors.
Question 5: Loan capital typically involves:
A) Selling shares to investors
B) Borrowing money to be repaid with interest
C) Short-term credit from suppliers
D) Receiving funds from business angels
Explanation: Loan capital involves borrowing money, typically from financial institutions, that must be repaid with interest over a set period.
Question 6: A bank overdraft allows a business to:
A) Borrow a fixed amount for a set period
B) Withdraw more money than is in its account
C) Obtain long-term loans with low interest
D) Issue new shares to investors
Explanation: A bank overdraft allows a business to withdraw more money than it currently has in its account, up to an agreed limit, providing short-term liquidity.
Question 7: Trade credit is:
A) A long-term loan from a bank
B) A short-term extension of credit by suppliers
C) Equity investment from business angels
D) Funds raised through crowdfunding
Explanation: Trade credit is a short-term financing option where suppliers allow a business to purchase goods or services on account and pay for them later.
Question 8: Crowdfunding involves:
A) Obtaining a loan from a financial institution
B) Raising small amounts of money from a large number of people
C) Borrowing money from friends and family
D) Receiving investment from a business angel
Explanation: Crowdfunding is a method of raising capital by soliciting small amounts of money from a large number of people, typically via online platforms.
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