Sole trader
Likely sources include the owner's savings, banks, suppliers and government grants or loans. A key difficulty is often providing collateral and persuading lenders that the business can repay.
Cambridge International AS & A Level Business · 9609 · AS Level
5.2 Sources of Finance
Businesses can obtain finance from many sources, but no source is automatically best. The right choice depends on who owns the business, why the money is needed, the time period, cost, risk, control and the financial position of the business.
Exam-focusedComplete Topic 5.2Interactive questions
What you need to know
High-mark answers do more than list sources of finance. You should be able to match a source to the circumstances, explain its advantages and disadvantages, and justify why one source or a mixture of sources may be more suitable than another.
High-grade habit: always link the finance source to the size and purpose of the funding, how long it is needed, the business' legal structure, ability to repay, existing debt and owners' willingness to share control.
Subtopics
These subtopics follow the textbook table of contents. Select one to jump directly to it.
5.2.1
Business ownership and sources of finance
The legal structure of a business affects which sources of finance it can use. A small start-up usually has fewer choices than a large established company because it may have little financial history, limited assets to offer as collateral and no retained earnings.
Partnership
Partners can invest their own funds and may obtain bank, supplier or government finance. Bringing in another partner can raise capital but may change control and profit sharing.
Private limited company
Possible sources include suppliers, banks, government finance, venture capital and private share issues. New shares may dilute existing owners' control and suitable investors may be difficult to find.
Public limited company
A plc has the broadest access, including bank finance, venture capital, government finance and public share issues. Its ability to raise funds can depend on recent performance, reputation, the economy and stock-market conditions.
Exam point: only companies can raise share capital. A public limited company generally finds it easier to sell shares because its shares can be traded more freely through a stock exchange.
5.2.2
Internal and external sources of finance
Internal finance
Finance generated from within the business or its existing resources.
- Owners' investment
- Retained earnings
- Sale of unwanted assets
- Sale and leaseback
- Working capital management
External finance
Funds provided from outside the business by individuals, institutions, suppliers or government.
- Share capital
- Overdrafts and bank loans
- Trade credit
- Leasing and hire purchase
- Mortgages and debentures
- Venture capital and new partners
- Debt factoring
- Microfinance and crowdfunding
- Government grants
Internal sources
Internal
Owners' investment
Owners may use savings, personal borrowing or money from friends and family. Investing their own money can also reassure lenders that the owners are committed.
- Advantage: may be quick and does not necessarily create business interest payments.
- Limitation: owners' funds are often limited and personal wealth may be at risk.
Internal
Retained earnings
Profits from earlier years kept in the business instead of being paid to owners or shareholders.
- Advantages: no loan interest and no need to issue new shares.
- Limitations: only available to profitable businesses; using it reduces the amount available for dividends or other uses.
Internal
Sale of unwanted assets
A business may sell land, buildings, equipment or other assets it no longer needs.
- Advantage: raises cash without creating loan repayments or diluting ownership.
- Limitation: the asset is no longer available to the business.
Internal
Sale and leaseback
The business sells an asset but immediately leases it back, so it receives cash while continuing to use the asset.
- Advantage: releases a large amount of capital without interrupting operations.
- Limitation: future lease payments increase costs.
Internal
Working capital
Cash can be released by reducing unnecessary inventory, collecting receivables faster and negotiating longer payment periods with suppliers.
- Advantage: makes better use of resources already in the business.
- Limitation: there are practical limits; reducing inventory too far or delaying suppliers too much can create new problems.
External sources
Equity
Share capital
A company sells ownership shares to investors. Shareholders may receive dividends and normally have voting rights.
- Advantages: can raise large sums; no fixed interest or compulsory repayment date.
- Limitations: issuing shares can be expensive and existing owners may lose some control.
Short term
Bank overdraft
The bank allows the business to spend beyond the money in its current account up to an agreed limit.
- Advantages: flexible and useful for temporary cash shortages; interest is paid only on the amount used.
- Limitations: interest can be high and the bank may demand repayment.
Short term
Trade credit
A supplier allows the business to receive goods or services now and pay later, commonly after 30–90 days.
- Advantage: acts like short-term interest-free finance.
- Limitation: generous credit may come with less favourable prices or may not be available to risky customers.
Asset finance
Hire purchase
The business obtains an asset and pays for it through instalments. Ownership usually passes to the business only after the final payment.
- Advantage: avoids a large immediate cash payment.
- Limitation: the total paid may be more than a cash purchase.
Asset finance
Leasing
The business pays to use an asset for an agreed period but does not own it.
- Advantage: access to expensive equipment without buying it outright.
- Limitation: regular lease payments continue and the business never owns the asset.
Loan capital
Bank loan
A bank provides an agreed sum which is repaid over time with interest. The bank may require collateral.
- Advantage: suitable for a defined medium- or long-term project and repayments can be planned.
- Limitation: interest increases costs and the business must repay even if profits are weak.
Property finance
Mortgage
A long-term loan used to buy land or buildings. The property usually acts as security.
- Advantage: can finance very large property purchases over a long period.
- Limitation: failure to repay can put the secured property at risk.
Long term
Debenture
A long-term form of loan capital, usually with a fixed rate of interest and often secured against non-current assets.
- Advantage: raises long-term finance without giving lenders voting rights.
- Limitation: fixed interest must be paid and the debt eventually repaid unless it is irredeemable.
High risk
Venture capital
Specialist investors provide finance, often as a mix of loan and share capital, to businesses considered relatively risky.
- Advantages: can provide finance when banks will not; investors may also offer expertise, contacts and advice.
- Limitations: owners may give up shares and some control, and the amount available may be limited.
Receivables
Debt factoring
A factor advances cash against unpaid customer invoices and then collects the debt from the customer.
- Advantages: improves cash flow quickly and can reduce the need for an overdraft.
- Limitations: the factor charges a fee and customers may interpret factoring as a sign of financial pressure.
Small business
Microfinance
Small-scale financial services, including loans, designed especially for low-income clients who may not have normal access to banks.
- Advantage: enables entrepreneurs with little collateral to start or expand income-generating activities.
- Limitation: the sums available are normally small.
Online finance
Crowdfunding
A large number of supporters each contribute relatively small amounts, often through an online platform.
- Advantages: may avoid traditional bank barriers and can also build a customer community.
- Limitations: success is uncertain and the business may need to offer rewards, interest, equity or early products.
Government
Government grant
Money given for a specified purpose, such as expansion, research or investment, subject to conditions.
- Advantage: normally does not have to be repaid if the conditions are met.
- Limitations: competition can be strong, eligibility is restricted and grants may cover only part of the project.
Ownership
New partners / private shareholders
A partnership can admit another partner, or a private company can sell additional shares to approved investors.
- Advantage: injects long-term capital without creating loan interest.
- Limitation: existing owners share future profits and decision-making power.
Leasing versus hire purchase
Hire purchaseThe business pays in instalments and normally becomes the owner after the final payment.
↔LeasingThe business rents the asset for an agreed period and never becomes its owner under the lease.
Debt factoring — how the cash arrives
1. Credit saleBusiness invoices customer.
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2. Invoice soldFactor advances up to about 80% immediately.
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3. Final settlementFactor collects from customer, pays the remainder and deducts its fee.
Example: if invoices worth $100,000 are factored and the factor advances 80%, the business receives $80,000 immediately. If the factor ultimately retains 5% of the invoice value as its charge, the total fee is $5,000.
Government grant calculation
Grant = 15% of start-up cost
If a 15% grant equals $375,000, total start-up cost = $375,000 ÷ 0.15 = $2,500,000.
5.2.3
Factors affecting sources of finance
Managers must compare the consequences of each source rather than simply choosing the cheapest-looking option.
CostConsider interest, fees, dividends, issue costs and any longer-term commitments.
Opportunity costUsing retained earnings reduces funds available for dividends or other investments; sale and leaseback creates future lease costs.
FlexibilityAn overdraft can rise and fall with short-term need, while grants may be tied to strict conditions.
ControlSelling shares, admitting partners or accepting venture capital may reduce the original owners' control.
Purpose and time periodThe source should match what the money will finance and how long it is needed.
Existing debtBusinesses already carrying substantial debt may find lenders unwilling to provide more and may need equity or internal finance instead.
Cost of finance
Loan finance creates interest costs. The rate may depend on the risk of the borrower, the length of the loan, prevailing interest rates and whether collateral is available. Share finance avoids compulsory interest but issuing shares can be expensive and can dilute control.
Important distinction: the sale of newly issued shares can raise finance for a company. The later resale of existing shares between investors on a stock exchange does not give new finance to the company.
Rights issues
A public limited company may raise share capital by offering new shares to existing shareholders in proportion to their current holdings. Because the administrative cost is lower than a full public issue, the new shares may be offered at a slight discount to encourage take-up.
Matching the purpose to the source
| Finance need | Sources that may fit | Why |
|---|---|---|
| Temporary working-capital shortage | Overdraft, trade credit, debt factoring | These are designed to deal with short-term cash timing problems. |
| Purchase of land/buildings | Mortgage, long-term loan, share capital | The asset is long-term and expensive, so long-term finance is more suitable. |
| Risky high-growth start-up | Owners' funds, venture capital, crowdfunding | Normal banks may consider the risk too high; specialist investors may accept more risk. |
| Established profitable expansion | Retained earnings, bank loan, shares | A profitable track record provides more internal funds and improves access to external finance. |
5.2.4
Selecting the source of finance
The final choice depends on the circumstances. Managers should consider several connected questions rather than applying a fixed rule.
1
How much is needed and for how long?
A small temporary cash shortage and a major factory investment require different sources.
2
What is the financial position?
Profitable businesses may have retained earnings and stronger evidence that loans can be repaid. A business with valuable assets may also be able to sell or mortgage them.
3
What is the business' reputation?
A reliable business may negotiate more supplier credit, lower borrowing costs or attract investors more easily.
4
What is the legal structure?
Sole traders cannot issue shares. Companies can use share capital, and public companies generally have the widest access to equity finance.
5
What is happening in the business environment?
High interest rates make borrowing more expensive. Strong market growth may increase confidence that future sales can support repayments.
No single source is always best
Businesses often use a mixture of sources. For example, a company expanding a factory might use retained earnings for part of the cost, a long-term loan for machinery and an overdraft for temporary working-capital needs. A mix can spread risk and reduce the disadvantages of relying on one source.
Evaluation framework: state the source → explain why it fits the purpose and time period → consider cost and risk → consider control and repayment → compare with an alternative → make a contextual judgement.
Quick selection guide
Short term?Consider overdraft, trade credit or factoring.
Long term?Consider loans, mortgages, debentures, shares or retained earnings.
High risk?Venture capital, crowdfunding or owners' funds may be more realistic.
Protect control?Prefer retained earnings or loan finance over issuing voting shares.
Already highly geared?Further borrowing may be difficult; equity or internal finance may be safer.
5.2 revision checklist
Explain how legal structure affects available finance.
Distinguish internal and external sources.
Explain owners' investment and retained earnings.
Distinguish sale of assets from sale and leaseback.
Explain how working-capital management can release cash.
Evaluate share capital as a source of finance.
Explain advantages and disadvantages of overdrafts and trade credit.
Distinguish leasing from hire purchase.
Explain bank loans, mortgages and debentures.
Evaluate venture capital for a risky business.
Explain how debt factoring works.
Explain microfinance and crowdfunding.
Evaluate government grants.
Explain how new partners can raise finance.
Analyse cost, opportunity cost and flexibility.
Explain how source choice can affect control.
Match finance sources to their purpose and time period.
Explain why existing debt can limit further borrowing.
Assess the business' financial position and reputation.
Justify a mixture of finance sources in context.
Questions open in a pop-up. Each answer is marked immediately, with an explanation so you know why it is correct or incorrect.