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Internal finance is a quick and easy way to solve short-term financial problems for most firms. It saves a business from borrowing from a lender and having to pay back interest.
What are the disadvantages of each source of internal finance?
Retained profits: profits that owners have reinvested into the business after paying costs and tax.
Owners’ funds: money put in by the owners themselves.
Sale of assets: a one-off way to raise money, generally used during financial struggles.
External sources of finance come from outside a business and are more difficult to arrange than internal sources.
Short-term finance: is used for daily expenses. It is sourced from an overdraft and is usually repaid in a year.
Long-term finance: is used to pay for major expenditure, such as buying new premises. Sources include: issuing shares, debentures, mortgages, venture capital and government grants. It is paid back over many years.
Medium-term finance: is used to pay for repairs and small improvements. Sources include: loans, hire purchase, trade credit and debt factoring. It is usually paid back over 1–5 years.
The owners of businesses often use their own savings to help them to start up. It is common for two or three people to combine their money to start up a business.
Advantages Disadvantages
Avoids interest on loans.
Owners keep complete control of the business.
If the owners remortgaged and the business fails, they could lose their homes.
There is a limit to how much money can be raised.
What are the advantages/disadvantages of this source?
When a business is performing well financially, it may choose to reuse some of the profits it made in previous years to help fund development/expansion projects.
It is similar to owners’ funds as there are no interest costs to pay.
What are the advantages/disadvantages of this source?
However, the business keeps full control of the new development/expansion because it will be using money that it already has.
But it may not leave the business with a buffer of funds to use if the project fails.
The British Government and European Union offer some financial assistance to help businesses which meet certain criteria, such as small businesses starting up, businesses in assisted areas or ones developing new technology.
These bodies give out grants, so no costs are involved. However, a grant can be recalled if a business does not keep to the conditions attached to it. Grants can also be small, meaning that other sources of finance can still be required.
The Department of Trade and Industry (DTI) is the government department responsible for helping UK businesses to operate efficiently.
When a business cannot afford to buy assets outright, such as vehicles, machinery and equipment, it could choose to hire purchase or lease them.
Leasing involves paying monthly instalments to use an asset, but a business doesn’t own it afterwards. Interest is charged for both sources, and the assets can be reclaimed if the repayments are not made.
When hire purchasing, a business must pay a deposit and monthly payments for the term of the agreement. At the end of the contract the business owns the assets.
A limited company (Ltd or plc) can issue shares in the company to raise extra finance.
The company keeps control of its day to day operations, but the shareholders become the owners and in theory would be able to vote for changes. A plc also becomes vulnerable to a hostile takeover.
Issuing shares poses no risk for a company but it will have to pay dividends to the shareholders every year to reward them for their investments. The shareholders do take on a risk as the value of shares can fluctuate.
Venture capital businesses are large businesses which lend money to smaller businesses, not plcs.
Venture capital companies often play an active role in the business in which they are investing. For example, they may choose to appoint people onto the board of directors or may even become involved in the running of it.
Look at the website of the TV programme Dragon’s Den to find out more about venture capital.
The lender becomes a shareholder in the business. Their aim is for the business to grow rapidly over a 3–7 year period so that the share price increases. Then the venture capitalist would sell its shareholding at a profit.