Internal and external sources of finance — common mistakes

When evaluating retained profit, always consider the opportunity cost. While it appears 'free', this capital could have been used to pay dividends. A good analysis will weigh the potential return from reinvestment against the need to keep shareholders satisfied.

In case studies, link the choice of finance directly to the need. If a business has a seasonal cash flow problem, a flexible overdraft is more appropriate than a long-term loan. Justify why the time period of the finance source matches the time period of the financial need.

When analysing debt finance, consider its impact on the Income Statement (interest is an expense, reducing profit) and the Statement of Financial Position (it's a non-current liability). High gearing can make a business vulnerable to increases in interest rates.

Never recommend share issue for a sole trader without first mentioning incorporation. Never use retained profit if the case says the firm made a loss.

Not necessarily. While internal finance, like retained profit, has no direct interest cost, it has a significant opportunity cost – the dividends forgone by shareholders. If the business cannot reinvest that profit to generate a return greater than what shareholders could get elsewhere, it may not be the 'best' use of the funds. Furthermore, internal sources are often limited in scale and may be insufficient for major expansion projects.

No. A bank loan is a form of debt finance, not equity finance. The business is borrowing money and is legally obligated to pay it back with interest. The bank does not gain any ownership or voting rights. Therefore, the owners retain full control. However, the loan agreement may include certain conditions or covenants that restrict the business's financial activities to protect the lender's investment.

No, this is a common misconception. Only incorporated businesses (private limited companies, Ltd, and public limited companies, plc) can issue shares. Sole traders and partnerships are unincorporated and cannot sell shares as they do not have a separate legal identity from their owners. For a plc, issuing shares to the public (flotation) is a very complex and expensive process regulated by stock exchange rules.