Sources of Finance
Internal and external ways businesses raise money, and how to choose the right source for a given situation.
- Distinguish between internal and external sources of finance
- Identify appropriate sources of finance for different business contexts (size, stage, purpose)
- Evaluate the advantages and disadvantages of specific sources of finance
Overview
Finance can come from internal sources (within the business) or external sources (outside the business). The most appropriate source depends on factors such as the amount needed, the time frame, the type of business, and the cost of finance.
Internal Sources of Finance
Internal sources do not require borrowing from outside parties. They tend to have no direct cost (no interest) but are limited in scale.
Personal Funds (sole traders / entrepreneurs)
The owner invests their own savings into the business. Common at start-up. No interest costs, but the owner bears all personal financial risk.
Retained Profit
Profit kept in the business after tax and dividends are paid. The most common internal source for established businesses. Free to use (no interest), but reduces how much profit is returned to shareholders.
Sale of Assets
Selling assets the business no longer needs (old machinery, property, surplus stock) to raise cash. Good for one-off injections but reduces the productive capacity of the business.
Retained profit: The portion of after-tax profit reinvested into the business rather than paid out as dividends. Also called "ploughed-back profit."
External Sources of Finance
| Source | Description | Best for | Key consideration |
|---|---|---|---|
| Share capital | Selling shares (equity) in the business to investors | Limited companies; large sums; long-term | Dilutes ownership; no repayment obligation |
| Loan capital | Borrowing a fixed sum from a bank, repaid with interest over time | Medium to long-term investment | Interest cost; requires collateral |
| Overdraft | Drawing more from a bank account than the balance | Short-term cash flow gaps | High interest; repayable on demand |
| Trade credit | Buying goods now, paying suppliers later (e.g. 30/60/90 days) | Day-to-day working capital | Interest-free if paid on time; damages supplier relationships if abused |
| Crowdfunding | Raising small amounts from many people, typically online | Start-ups; creative projects; early validation | Public exposure; reward/equity offered; not guaranteed |
| Leasing | Renting an asset rather than purchasing it outright | Expensive equipment without upfront capital | Never own the asset; ongoing payments |
| Microfinance providers | Small loans for entrepreneurs in developing countries or with no credit history | Start-ups in developing economies | Small amounts; high interest; social mission |
| Business angels | Wealthy individuals investing in start-ups in exchange for equity | Early-stage businesses with growth potential | Dilutes ownership; angels bring expertise and networks |
Choosing the Right Source
The appropriate source of finance depends on several factors:
| Factor | Implication |
|---|---|
| Amount needed | Large sums → loan capital, share capital; small sums → overdraft, trade credit |
| Time period | Short-term needs → overdraft, trade credit; long-term investment → share/loan capital |
| Type of business | Sole traders can't issue shares; PLCs have more options |
| Cost of finance | Interest rates, dividends, equity dilution all have a cost |
| Risk | High debt increases financial risk; equity sharing reduces control |
| Stage of business | Start-ups have fewer options; established businesses can use retained profit |
Never just list sources — always evaluate appropriateness. A short-term cash flow crisis calls for an overdraft or trade credit, not a 10-year bank loan. Match the source to the duration and scale of the need.
Key Terms
- Internal sources: personal funds, retained profit, sale of assets
- External sources: share capital, loan capital, overdraft, trade credit, crowdfunding, leasing, microfinance, business angels
- Short-term needs → overdraft, trade credit
- Long-term needs → share capital, loan capital, leasing
- The appropriate source depends on amount, time frame, business type, and cost
- Sole traders cannot issue shares
Show answer
An overdraft or personal funds would be most appropriate.
An overdraft is designed for short-term cash flow gaps — the business only needs the money for three months and can repay as revenue comes in. It is flexible and quickly arranged. Personal funds avoid any interest cost entirely.
A long-term bank loan would be inappropriate because the need is temporary and a loan would leave the business repaying interest for years on a short-term problem.
Common mistake: Recommending a source without justifying it in the context of the question. The answer must connect the source to the specific circumstances — short-term need, small amount, no collateral. Saying "a bank loan is a good source" with no context scores poorly.
Show answer
Share capital involves selling ownership (equity) in the business. Shareholders become part-owners, may receive dividends, and the money does not need to be repaid. However, control is diluted.
Loan capital is debt — borrowed money that must be repaid with interest over an agreed period. The lender has no ownership stake but the business has a legal obligation to repay.
Award 1 mark per valid point of distinction, up to 4.
Common mistake: Treating "distinguish" as "define both terms separately." A distinction must show a contrast — the answer should explicitly compare them, e.g. "Unlike loan capital, share capital does not require repayment…"
Show answer
Business angel: A business angel could provide the full $200,000 in exchange for equity. They bring not just money but mentorship and networks — valuable for a tech start-up. However, the founders dilute their ownership and may lose some control over direction.
Crowdfunding: An equity or reward-based crowdfunding campaign could raise funds while simultaneously building a customer base. However, there is no guarantee of reaching the target, and developing/fulfilling rewards adds cost and complexity.
A bank loan is unlikely because the start-up has no assets as collateral and no trading history. Award marks for evaluation (weighing pros/cons for the specific situation).
Common mistake: Listing advantages and disadvantages without linking them to the scenario. "Crowdfunding is risky" scores less than "Crowdfunding may not reach its target — leaving the start-up with no funding at all at a critical stage of development."