Revise Internal and external sources of finance for Cambridge 9609 (5.2.2)

Internal finance is capital generated from within the business itself, without recourse to external providers. The two primary sources are retained profit and the sale of non-current assets. Retained profit is the net profit after tax and dividends that is ploughed back into the business. It is often seen as the cheapest source as there are no direct interest costs. Selling redundant or underutilised assets, such as machinery or property, can also inject significant cash. While these methods avoid debt and dilution of ownership, they are not without drawbacks. The amount available is finite, and using retained profits has an opportunity cost – that money could have been distributed to shareholders as dividends, potentially causing dissatisfaction if returns are not high enough.

External short-term finance is required to manage the day-to-day running of a business and cover temporary shortages in working capital. It is typically repayable within one year. Key sources include bank overdrafts, trade credit, and debt factoring. An overdraft is a flexible arrangement allowing a business to spend more than is in its current account, up to an agreed limit, but often carries high interest rates. Trade credit, offered by suppliers, allows a business to 'buy now, pay later', usually within 30-90 days. Debt factoring involves selling trade receivables (invoices) to a third-party company at a discount to receive immediate cash. This improves cash flow but reduces the profit margin on each sale.

Long-term debt finance involves borrowing capital from an external source that will be paid back over a period greater than one year. Common forms include bank loans and debentures. A bank loan is a fixed sum borrowed for a specific purpose, repaid with interest over a set period. Debentures are long-term loans issued by companies, often with a fixed rate of interest, to raise capital from the public or institutions. The key advantage of debt is that ownership is not diluted; shareholders retain their full control. However, the business is legally obliged to make regular interest payments, which increases fixed costs and financial risk. A high level of debt finance increases a company's gearing, which can deter potential investors if it is considered too risky.

Equity finance is permanent capital raised from external sources in exchange for a share of ownership in the business. For limited companies, the primary method is issuing shares. A private limited company (Ltd) can sell shares to friends, family, or venture capitalists, while a public limited company (plc) can sell shares to the general public on a stock exchange. Unlike debt, there is no legal obligation to repay the capital or pay dividends. This makes it less risky in terms of cash flow. However, issuing new shares dilutes the ownership and control of existing shareholders. New shareholders will also expect a return on their investment through future dividend payments and an increase in share value, creating pressure on management to perform.

The most critical skill is selecting the appropriate source of finance by analysing the business's specific situation. The choice depends on several interconnected factors. Consider the Purpose: is the finance for a long-term project like a new factory (requiring a loan or share issue) or a short-term cash flow gap (requiring an overdraft)? The Amount needed is also key; small amounts might be raised internally, whereas large-scale expansion requires external sources. The Legal structure dictates options: a sole trader cannot issue shares, while a plc can. Finally, consider the Cost and Risk: debt increases gearing but retains control, while equity dilutes control but is less risky from a cash flow perspective. The existing financial position and the state of the economy also influence the final decision.

Retained profit — profit kept in the business rather than paid as dividends. Main source for established profitable firms.

Sale of assets — sell unused property, equipment, or investments.

Improve working capital management — reduce inventory, collect receivables faster (releases cash without external finance).