Revision notes
Business Finance
Internal sources of finance come from inside the business: money it has already earned, or things it already owns. The two internal sources are retained profit and selling assets.
Retained profit
Retained profit is profit kept in the business instead of being paid out to the owners. Rather than taking all of the profit, the owners agree to leave some behind, where it builds up as a reserve the business can spend on growth.
Because it is the business's own money, retained profit can fund growth without borrowing. That avoids interest payments and the repayment of loan capital, so growth costs less overall and the owners keep full control of the business.
For example, a bicycle repair workshop making £60,000 profit might keep £21,000 of it towards fitting out a second workshop, paying no interest on that money. The catch is that retained profit is limited to the profit the business actually makes: a new business, or one with thin profit margins, may not earn enough to pay for large-scale growth, and owners must wait longer for a return.
Selling assets
Selling assets means raising finance by selling resources the business already owns, such as machinery, vehicles or property. It raises money without creating debt, because there is no loan to repay and no interest to pay, which keeps financial risk down.
However, the business may lose resources it needs. Sell a delivery van and deliveries slow down unless another van is hired or bought, which adds cost and reduces capacity, so the business becomes less efficient. The finance raised can then cost more in lost output than it provides.
| Internal source | Where the money comes from | Main drawback |
|---|---|---|
| Retained profit | Profit kept back instead of paid to owners | Limited to the profit the business actually makes |
| Selling assets | Sale of resources the business owns | May lose resources it needs to operate |
External sources of finance come from outside the business, usually from a lender such as a bank, or from investors who put money in.
Loan capital
Loan capital is money borrowed by the business that must be repaid, with interest added on top. For example, a garden centre might borrow £40,000 to build a second glasshouse and repay it in monthly instalments over five years.
The main benefits are speed and size: a large sum can arrive quickly, and because the lender is only owed money and does not become an owner, the existing owners keep control of decisions. The drawbacks are cost and risk. Interest makes the borrowing cost more than the amount received, and the repayments must be made even in a quiet month, which can squeeze cash flow and increase financial risk — the danger of being unable to keep up repayments if sales fall.
Share capital
Share capital is raised by selling shares in a company, so investors pay money in and become part owners. It does not have to be repaid and no interest is charged, which makes it less of a drain on cash than a loan.
In return, shareholders may expect a share of the profit as dividends, and they usually expect a say in how the business is run. Selling new shares also dilutes existing owners' control. If two owners each held 50% and new shares are sold so that outsiders own 40%, each original owner falls to 30%. The two of them still hold 60% between them and keep control if they vote together, but neither can outvote the new shareholders alone.
| Feature | Loan capital | Share capital |
|---|---|---|
| Comes from | A lender, e.g. a bank | Investors buying shares |
| Repaid? | Yes, plus interest | No, and no interest |
| Effect on control | Owners keep control | Control may be diluted |
| Ongoing cost | Regular repayments | Possible dividends |
When a business needs money to grow, it compares the sources of finance available. Internal sources come from inside the business, such as retained profit or selling assets; external sources come from outside, such as loan capital or share capital.
Internal sources are usually cheaper because there is no interest, fee or dividend to pay, and owners keep control of the money. Their weakness is the amount: a business can only use profit it has kept or sell assets it owns, which may be far below what a big expansion needs. Selling an asset can also remove something useful, such as a machine.
External sources raise larger sums, often quickly: a loan can be arranged in weeks, and a limited company can issue shares to many investors. They add costs, because loans are repaid with interest, and share capital, which never has to be repaid, may bring dividend payments. They can also reduce control, as lenders set conditions and new shareholders gain voting rights.
Weighing up the choice
| Factor | Internal sources | External sources |
|---|---|---|
| Cost | Usually lower: no interest or dividends | Higher: interest, fees, dividends |
| Speed | Money already held can be used at once | Loans can be arranged quickly; share issues take longer |
| Amount | Limited to profit kept or assets owned | Much larger sums possible |
| Risk | Lower financial risk | Higher if repayments are missed |
| Control | Owners keep control | May reduce control |
Cost, speed, risk, control and the amount needed are the main factors, and the same five help you compare other routes to growth, such as a merger or a takeover.
Worked example
A chain of three indoor climbing centres wants £150,000 for a fourth site and has £40,000 of retained profit. Using that is cheap and keeps control, but leaves £110,000 to find. A £110,000 loan is quick and large enough, but interest raises monthly costs and the lender may ask for security. Issuing shares could raise the money without interest, but the owners would lose some control. The best choice depends on how soon the site must open, the profit it should make and how much control the owners will give up.