Chapter 25 · Sources of Finance
How do businesses raise money to start, operate and grow—and how can they choose an appropriate source?
Learning objectives
- Explain why businesses need finance for short-term, long-term, start-up and expansion purposes.
- Describe internal sources: personal savings, retained profit and selling assets.
- Compare external sources including overdrafts, trade payables, loans, share capital, venture capital and crowd funding.
The Need for Funds
Most businesses need finance to begin trading, pay everyday expenses and expand. The amount and source should match what the money is needed for and how long it will be needed. Financial needs include short-term costs, long-term projects, start-up capital and expansion.
Short-Term Needs
When a business sells goods, it may not receive cash immediately. Yet wages, raw materials, utility bills and premises still have to be paid for. Short-term finance helps bridge a temporary gap between cash going out and cash coming in. It is usually repaid within one year. For instance, a seasonal retailer might borrow money to buy stock before its busiest period.
Long-Term Needs
Businesses need long-term funds for items used over many years: buildings, machinery, vehicles and major equipment. Loans or other finance lasting longer than one year may spread their cost over the period in which they provide benefits. Long-term finance can also support a substantial expansion. It should be planned carefully because repayments or other financial commitments may continue for years.
Start-Up Capital
A new business may have to pay for equipment, legal fees, premises, branding, a website and marketing before it earns any sales revenue. Start-up capital covers these initial costs. In practice, entrepreneurs often put their own savings at risk, but many need finance from elsewhere because their savings are not enough.
Expansion
Successful businesses may want to increase production capacity, develop new products, enter overseas markets or diversify. Such plans can require expensive premises, equipment, additional workers and marketing. A business should choose a suitable source of money rather than rely on short-term borrowing for every long-term investment.
Maurice started an airport taxi service in 2016 using KES 2 million in savings and a KES 2 million, five-year bank loan at a stated fixed interest rate of 8% per annum. He needed a vehicle, insurance and advertising to operate between Nairobi and Jomo Kenyatta International Airport. His savings are internal finance; his bank loan is external finance. If the loan uses flat simple interest, the total interest is KES 2,000,000 × 8% × 5 = KES 800,000; 60 equal instalments would then be KES 46,666.67 each. An amortising loan would be calculated differently.
In 2016, Tribal Group sought financial stability after a fall in revenue and losses. It planned to sell 94.8 million shares at 22p each to existing shareholders and sold its Synergy operation for £20.3 million in cash. These illustrate raising share capital and selling assets. The share issue would raise about £20.856 million before issue expenses (94.8 million × £0.22). These are historical figures, not current company results.
Internal Sources of Finance
Internal finance comes from inside the business, without obtaining funds from an outside lender or investor. It can be relatively inexpensive and does not normally add loan-interest charges. However, businesses can use these sources only when the money or assets are available, and owners may have to make sacrifices.
Personal Savings
Entrepreneurs frequently use their own money to set up a business. They may also obtain gifts or loans from family and friends. Savings are straightforward to use and do not normally incur bank-loan interest. The drawback is personal financial risk: if the business fails, the owner may lose money saved over many years. Maurice Obuya’s start-up savings illustrate this method.
Retained Profit
When an established business makes a profit it can keep some of that money for later investment instead of distributing it. Retained profit does not require interest payments, and the business can choose when and how to use it. But retaining profit means owners receive less now, and an unprofitable or new business may have little or no retained profit available. It is also worth noting that retained funds may be saved to earn interest.
Selling Assets
A business may raise cash by selling machinery, land, buildings or another part of its operations that it no longer needs. This avoids a new loan, but the assets sold can no longer be used unless the business arranges to lease them back. Selling an essential asset may damage future operations. For example, Tribal Group’s £20.3 million sale of Synergy in 2016 raised cash without issuing debt.
In 2014 Nikki started a wedding-planning business in Pune, India. she raised Rs 90,000: Rs 30,000 in personal savings, Rs 10,000 as a gift from her grandfather, Rs 20,000 as an interest-free loan from her father and Rs 30,000 as a bank loan. The bank provided 33⅓% of the total (30,000 ÷ 90,000 × 100). Her own savings covered another 33⅓%. Personal savings are an internal source; gifts and loans from family are additional sources of finance.
Choosing internal finance: it can limit borrowing costs and preserve control, but owners must consider the opportunity cost of using personal savings or retaining profits rather than distributing them.
Check your understanding · Halfway
Try each question before opening its suggested answer.
Distinguish short-term finance from long-term finance and give one appropriate use for each.
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Short-term finance is normally borrowed for one year or less, for example to buy stock before sales. Long-term finance lasts more than a year and can fund premises, vehicles or machinery.
Give two reasons why a start-up may need finance before making its first sale.
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For example, equipment and premises, or legal fees and marketing. Start-up costs have to be paid before trading revenue becomes available.
Explain the difference between retained profit and personal savings.
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Retained profit is money earned by an established business and kept for future use. Personal savings are funds contributed by the owner from their own resources.
What were the two main sources of finance for Maurice Obuya’s taxi business?
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KES 2 million of his personal savings (internal finance) and a KES 2 million five-year bank loan (external finance).
A new business raises Rs 90,000: Rs 30,000 from a bank, Rs 30,000 in savings and Rs 30,000 from family. What percentage came from the bank?
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Bank finance = (30,000 ÷ 90,000) × 100 = 33⅓% (approximately 33.3%).
Explain one advantage and one risk of financing expansion by selling assets.
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Selling unneeded assets can generate cash without borrowing interest. However, selling assets that remain useful could reduce capacity or lead to additional leasing costs.
External Sources of Finance
External finance comes from outside the business. It includes short-term sources for temporary cash shortages and longer-term sources for large investments. The main types of external finance have different advantages and limitations.
Bank Overdraft
An overdraft allows the business to spend more than the cash balance in its bank account, up to an agreed limit. Interest is generally charged on the amount overdrawn, making this source flexible for short-term needs. However, the bank can require the business to repay it, and repeated overdrafts can become expensive. It is unsuitable for financing major assets over many years.
Trade Payables
Trade credit allows a firm to obtain supplies now and pay later, often after 30–90 days. This helps preserve cash while the goods are turned into sales. It may be a cheap form of short-term finance, but the business could lose early-payment discounts, pay more than a cash buyer or damage supplier relationships by delaying payments. The amounts owed to suppliers are called trade payables.
Credit Cards
A business credit card provides a convenient way to pay for purchases. In practice, interest may be avoided if the balance is cleared within the credit period; it gives 56 days as a typical historical example. Interest charges can be high if the balance is not repaid promptly, so cards are best suited to modest and manageable short-term spending.
Loan Capital
With a bank loan, a firm borrows an agreed amount and repays it, plus interest, according to a schedule. Knowing the instalment amount helps budgeting. Loans can be short or long term, but repayments still fall due even when sales are weak. The lender may examine the firm’s ability to repay and request security. Maurice Obuya’s five-year loan illustrates this type of finance.
Unsecured bank loans
An unsecured loan is not backed by specific assets pledged as security. This avoids risking a named property as collateral, but lenders face greater risk and may charge higher interest or reject the application. This illustrates why some smaller firms may struggle to secure these loans.
Mortgages
A mortgage is a loan secured on land or property. Because the property is collateral, rates may be lower than on unsecured loans. If the borrower fails to pay, the lender may take possession of the property. Mortgages usually suit property purchases or other long-term needs rather than routine bills. Some mortgages are repaid over 25 years or longer, depending on the lender and loan terms.
Debenture
A debenture is described as a long-term security issued by a company, usually paying a fixed return and secured against assets. Debenture holders are creditors, not owners: they do not receive shareholder voting rights, and the amount is repaid on the agreed date. The obligation to pay interest and repay the debt is a disadvantage for the company.
Hire purchase
Hire purchase (HP) helps firms obtain vehicles, machinery and equipment. Usually the business makes a deposit and pays regular instalments. Under a typical hire-purchase agreement, legal ownership passes after the final instalment; falling behind may result in repossession. HP makes major purchases possible without the full cash price at once but can cost more overall than some bank loans.
Share Capital
Limited companies may raise money by selling shares. Shareholders own part of the company and may expect dividends, but share capital is generally permanent capital: it is not normally repayable as an ordinary loan while the company continues to trade. A rights issue offers new shares to existing shareholders, often at a discount. A public limited company may raise significant funds through a stock-market flotation. However, issuing shares incurs administrative costs and can dilute existing ownership or control.
Venture Capital
Venture capitalists are investors who provide money to businesses, often small or medium-sized technology firms with significant growth potential. In exchange they usually take a stake in the firm and may influence decisions. Some private investors are called business angels. This finance may be available when a bank is unwilling to lend, but the owners must share future profits and some control. Individual investment amounts vary considerably; £10,000–£100,000 is only an illustrative range, not a rule.
Crowd Funding
Crowd funding brings together many individuals who contribute relatively small sums, usually through an online platform. Depending on the arrangement, backers may receive rewards, equity or repayment terms; in equity crowdfunding, supporters receive an ownership interest in the venture. This can give a small firm access to money and public interest, but success is not guaranteed and the business may need to disclose its plans to potential supporters.
Marine Techno developed make-up using recycled marine by-products and could not easily raise finance outside Seoul’s wider region. Using a crowd-funding website, it sought KRW 80 million in 2016, achieved that within the first day, and had raised KRW 127 million by the end of the week. Funds raised were KRW 47 million above the target, or 58.75% more (47 ÷ 80 × 100). The example is historical; it is not a current report on the firm.
Short-term external sources
- Bank overdraft — flexible, but repayable on demand.
- Trade credit — postpones cash payments, but can strain supplier relationships.
- Credit cards — convenient, but high interest if balances remain unpaid.
Longer-term external sources
- Loans, mortgages and debentures — repayable debt with costs.
- Hire purchase — staged payments for assets.
- Shares, venture capital and crowd funding — potentially substantial funds, but may affect control or carry other commitments.
Large vs Small Businesses
A small sole trader may rely on personal savings, family help, a bank loan, a small mortgage or other modest sources. New businesses have little retained profit and may be judged risky by lenders. A small company with strong growth potential may seek venture capital or crowd funding instead.
Large public and private limited companies often have a wider range of options, including substantial loans, selling assets, retained profits and issues of shares. Their size and assets may help them obtain finance on more favourable terms, although financial risks do not disappear.
Best choice depends on: the sum required; purpose and time period; interest and other costs; availability of security; repayment risk; and whether the owners are willing to share control. A business will often combine more than one source of finance, as Maurice Obuya and Nikki Rani did.
A café that needs ingredients for a busy weekend might use trade credit or a modest overdraft. A firm purchasing a warehouse might need long-term finance such as a mortgage. A rapidly expanding technology company might prefer new equity from investors if regular loan repayments would be difficult.
End-of-chapter questions
Try each question before opening its suggested answer.
State three reasons why businesses need money.
Show suggested answer
To fund start-up costs, cover everyday operating expenses, and buy long-term assets or expand operations. Other valid examples include developing products and entering overseas markets.
Why might a seasonal business prefer a bank overdraft to a long-term loan?
Show suggested answer
A seasonal cash gap may last only a short period. An overdraft can be flexible and interest is charged on the amount used, although the bank can demand repayment.
Explain one advantage and one disadvantage of using trade payables.
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Trade credit postpones payment for supplies, helping cash flow. The business may forgo discounts, pay more for supplies or upset suppliers if it delays payment too long.
Assuming flat simple interest, find the total interest on a KES 2 million five-year loan at 8% per year.
Show suggested answer
Interest = 2,000,000 × 0.08 × 5 = KES 800,000. Total repayment = KES 2.8 million, or approximately KES 46,666.67 for each of 60 equal instalments, ignoring fees.
What is the difference between a secured mortgage and an unsecured bank loan?
Show suggested answer
A mortgage is secured against property the lender may repossess after default. An unsecured loan lacks security over a specific asset and may carry a higher interest rate.
State two features of a hire-purchase agreement.
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Typically a deposit followed by instalments, with legal ownership transferring after the final payment; goods may be repossessed after missed payments.
How do debenture holders differ from shareholders?
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Debenture holders are creditors who are generally promised interest and repayment at maturity and have no shareholder votes. Shareholders are owners who may receive dividends and hold voting rights.
Calculate the gross amount Tribal Group planned to raise from issuing 94.8 million shares at 22p each.
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94.8 million × £0.22 = £20.856 million before issue costs.
How much did Marine Techno exceed its KRW 80 million crowd-funding target by raising KRW 127 million?
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KRW 127m − KRW 80m = KRW 47 million. As a percentage of the target: 47 ÷ 80 × 100 = 58.75%.
Evaluate the benefits and limitations of venture capital for a small technology business.
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It may provide substantial finance and investor expertise when banks are reluctant. However, investors usually take ownership and expect returns, so founders must share profits and potentially decision-making. Suitability depends on growth potential and how much control owners wish to retain.
A new manufacturing firm needs funds for premises, machinery and a few months of stock. Recommend a sensible combination of sources, with reasons.
Show suggested answer
Use appropriately long-term finance—perhaps a mortgage for premises and hire purchase or a term loan for machinery—while funding temporary stock needs with trade credit or a carefully limited overdraft. Owner savings or equity may reduce debt burden. The best mix depends on repayment capacity, available security and owners’ willingness to share control.
Chapter 25 recap
Businesses need funds to start, pay day-to-day expenses and invest. Internal finance includes savings, retained profit and selling assets. External finance includes short-term credit, loans and longer-term debt or equity. The right source depends on cost, purpose, repayment period, risk and control.
Educational adaptation of Pearson Edexcel International GCSE (9–1) Business, Chapter 25 (source pp. 210–217). Examples and figures are for revision; historical figures do not describe current company performance. IGCSE360 is an independent learning resource and is not affiliated with Pearson.