Businesses need finance for a variety of reasons: to start up, operate day‑to‑day, grow, develop new products and invest in assets. Choosing the right source of finance depends on the amount required, the time period and the cost.
Reasons for finance
- Start‑up capital – purchasing equipment, premises and initial stock.
- Working capital – paying day‑to‑day expenses before revenue is received.
- Expansion – funding new products, additional premises or acquisitions.
- Research and development – investing in innovation and product design.
- Special situations – such as cash flow problems or emergencies.
Short‑, medium‑ and long‑term finance
Finance is often categorised by time:
- Short‑term (up to 1 year) – used for working capital. Sources include overdrafts, trade credit and factoring.
- Medium‑term (1–5 years) – used for replacing equipment or purchasing vehicles. Sources include bank loans, leasing and hire purchase.
- Long‑term (more than 5 years) – used for major expansions. Sources include share issues, debentures, long‑term loans and venture capital.
Internal sources of finance
Finance generated from within the business:
- Retained profit – profit kept in the business after dividends are paid.
- Sale of assets – selling unused equipment or property.
- Owner’s savings – personal savings invested by the owner(s) of a small business.
Internal sources are cheap and do not increase debt but may be limited in amount.
External sources of finance
Finance obtained from outside the business:
- Bank loans and mortgages – fixed amounts repaid with interest over an agreed period.
- Overdrafts – flexible borrowing up to an agreed limit on a bank account; interest is charged on the overdrawn amount.
- Trade credit – buying goods or services and paying at a later date.
- Leasing – renting equipment in return for monthly payments; the business does not own the asset.
- Hire purchase – paying for an asset in instalments; ownership passes to the buyer once payments are complete.
- Factoring – selling trade receivables to a factor (finance company) for immediate cash.
- Grants and subsidies – financial assistance from government or other organisations, often with conditions.
- Share capital – issuing shares to investors (only available to companies). New shareholders bring in additional funds but dilute ownership.
- Debentures – long‑term loans issued by companies and secured against assets.
- Venture capital and business angels – investors who provide capital in exchange for a share of ownership and influence.
- Crowd funding – raising small amounts of money from a large number of people, typically via online platforms.
The choice of finance depends on factors such as the legal structure of the business, the amount required, risk, cost of finance and whether owners are willing to give up some control.
Advantages and disadvantages of internal sources
Retained profit
Advantages:
- No interest or repayment obligations – the business finances growth from its own earnings.
- Immediately available once profit has been retained, providing flexibility.
- Does not dilute ownership or control of the business.
Disadvantages:
- Limited by the amount of profit generated; may be insufficient for large expansions.
- Shareholders may expect dividends – retaining too much profit could cause dissatisfaction.
- Using retained profit reduces reserves that could cushion future downturns.
Sale of assets
Advantages:
- Raises cash from under‑utilised or obsolete assets, freeing up space and reducing maintenance costs.
- No interest payable and no increase in debt.
Disadvantages:
- Assets sold are no longer available for future use; hiring or replacing them can be expensive.
- May take time to find a buyer and assets might be sold below their book value.
- One‑off source of finance – cannot be used repeatedly.
Owner’s savings
Advantages:
- Quick and easy to obtain for small businesses.
- No interest to pay and no formal agreement required.
- Owners retain full control over the business.
Disadvantages:
- Limited to the owner’s personal funds; may not meet large capital needs.
- Personal finances are at risk if the business fails.
- Using personal savings may affect the owner’s lifestyle or family finances.
Advantages and disadvantages of external sources
Bank loans and mortgages
Advantages:
- Provide large sums of capital for a fixed period, useful for investment in equipment, property or expansion.
- Structured repayment schedule helps with budgeting and financial planning.
- Interest rates may be lower than overdrafts and the cost is known in advance.
Disadvantages:
- Interest charges increase costs and reduce profitability.
- Collateral may be required; assets could be at risk if repayments are not made.
- Regular repayments must be made regardless of business performance, affecting cash flow.
Overdrafts
Advantages:
- Flexible – can be used to cover short‑term cash shortages and repaid when income is received.
- Interest is only paid on the amount overdrawn and for the period it is used.
- No collateral is usually required for small overdrafts.
Disadvantages:
- Interest rates are generally higher than bank loans.
- May be repayable on demand, creating uncertainty.
- Banks can reduce or withdraw the facility at short notice.
Trade credit
Advantages:
- Allows the business to obtain goods or services and pay at a later date, improving short‑term cash flow.
- No interest cost if suppliers’ payment terms are met.
- Convenient and easy to arrange with regular suppliers.
Disadvantages:
- May lose discounts for prompt payment.
- Late payments can damage relationships with suppliers and harm credit ratings.
- Only suitable for short‑term financing of working capital.
Leasing
Advantages:
- No large initial outlay – the asset is paid for over its life.
- Lease payments often include maintenance and service.
- Enables businesses to use the latest equipment without the risk of obsolescence.
Disadvantages:
- Total cost of leasing may exceed the cost of buying the asset outright.
- Business never owns the asset unless there is a purchase option; it must be returned at the end of the lease.
- Lease agreements can be inflexible – ending them early may incur penalties.
Hire purchase
Advantages:
- Enables the purchase of assets with monthly payments, spreading the cost over time.
- Business has use of the asset while paying for it.
- Simple to arrange and often available from suppliers.
Disadvantages:
- Interest charges increase the overall cost of the asset.
- The asset is not owned until the final payment is made; failure to pay may result in repossession.
- Commitment to payments can strain cash flow if revenues decline.
Factoring
Advantages:
- Provides immediate cash by selling trade receivables to a finance company.
- Reduces the risk of bad debts and saves time on chasing late payments.
- Can improve cash flow and allow the business to focus on core activities.
Disadvantages:
- The factor charges a fee and may only advance a percentage of the invoice value, reducing overall revenue.
- Customers may feel pressured by a third‑party debt collector, potentially damaging relationships.
- Only suitable for businesses with trade receivables.
Grants and subsidies
Advantages:
- Do not need to be repaid, reducing the financial burden.
- Encourage investment in specific activities such as job creation, research, training or environmentally friendly projects.
- Can improve a business’s reputation by aligning it with government priorities.
Disadvantages:
- Usually come with conditions and restrictions on how funds are used.
- Competition for grants is strong and the application process can be time‑consuming.
- Funding is often one‑off or limited to a specific period.
Share capital
Advantages:
- Can raise large amounts of permanent finance for companies.
- No interest payments – dividends are payable only if profits are made.
- Reduces the company’s gearing (debt‑equity ratio).
Disadvantages:
- New share issues dilute existing owners’ control and profit share.
- Shareholders expect dividends and may pressure management for short‑term results.
- The process of issuing shares can be expensive and is subject to regulations (especially for public limited companies).
Debentures
Advantages:
- Provide long‑term finance at a fixed rate of interest.
- Do not dilute ownership – debenture holders are creditors, not owners.
- Can be attractive to investors seeking stable returns.
Disadvantages:
- Interest must be paid even if the business makes a loss.
- Increases gearing and financial risk.
- Usually secured against the company’s assets – failure to repay could lead to assets being seized.
Venture capital and business angels
Advantages:
- Provide capital for high‑risk, high‑growth ventures that may not attract bank finance.
- Bring expertise, mentoring and contacts to help the business grow.
- May accept higher risk in exchange for potential high returns.
Disadvantages:
- Require a share of ownership and profits, reducing the founder’s control.
- Investors expect high returns and may push for rapid growth or exit strategies.
- Due diligence and negotiations can be lengthy and intrusive.
Crowdfunding
Advantages:
- Allows businesses to raise small amounts of money from a large number of people, often via online platforms.
- Provides market validation and publicity for a new product or idea.
- No interest payments if funds are raised through donations or rewards (rather than equity).
Disadvantages:
- May not reach the funding target – funds are usually returned if the target is not met.
- Platforms charge fees and successful campaigns require marketing effort.
- Ideas become public; competitors could copy them.
| Source | Type | Advantages | Disadvantages |
|---|---|---|---|
| Retained profit | Internal | Free of interest; readily available; no dilution of control. | Limited by profitability; shareholders may expect dividends. |
| Owner’s savings | Internal | No interest to pay; full control maintained. | Limited to personal funds; risk to personal wealth. |
| Bank loan | External | Large sums can be borrowed; fixed repayment schedule. | Interest increases costs; collateral may be required; repayments reduce cash flow. |
| Overdraft | External | Flexible borrowing for short periods; interest only on amount used. | Higher interest rate than loans; repayable on demand. |
| Leasing | External | No large initial outlay; maintenance often included. | Total cost may exceed purchase price; no ownership. |
| Share issue | External (companies) | Large amounts of capital; no interest; permanent finance. | Dividends expected; dilution of control; costly to arrange for plcs. |
| Venture capital | External | Access to expertise and capital; suitable for risky projects. | Loss of control; profit sharing; high expectations from investors. |
Examples and applications
A new café owner might use personal savings and a bank loan to buy equipment and pay rent until the business generates enough revenue. As the café grows, it may retain profits to finance refurbishment or take out a medium‑term loan to purchase a delivery vehicle. Small businesses often rely on trade credit by buying supplies from wholesalers and paying after 30 days; this helps cash flow without needing to borrow from a bank.
For major expansion, such as building a new factory, a large company may issue shares on the stock market or sell debentures. Innovative start‑ups frequently turn to venture capitalists or business angels who provide capital and expertise in exchange for a share of the business. Crowdfunding platforms allow entrepreneurs to raise small amounts from many supporters, sometimes offering early access to products as a reward. The chosen mix of finance depends on the cost, risk and control implications.
