sources-of-finance internal-sources-of-finance

An introduction to sources of finance

• Businesses have different sources of finance available to them

  • When the finance comes from inside the business, it is called an internal source of finance

  • When the finance comes from outside the business, it is called an external source of finance

Internal and external sources of finance

Owner’s investment

• Owners’ investment is a key source of funds when a business starts up

  • Owners may introduce their savings or another lump sum, e.g. money received following a redundancy

• Owners may invest more as the business grows or if there is a specific need, e.g. a short-term cash-flow problem 

Evaluating owner’s investment

Retained earnings

• This is profit generated in previous years and not distributed to owners that is reinvested in the business

• This is a cheap source of finance, as it does not involve borrowing and associated interest and arrangement fees

• The opportunity cost of investing the money back into the business is that shareholders do not receive extra profit for their investments

Evaluating the use of retained earnings

Sale of unwanted assets

• Selling fixed assets that are no longer required, such as machinery, land or buildings, generates finance

• Businesses use this method for a range of reasons

  • To raise cash quickly without taking on debt

  • To free up capital tied up in unused or outdated assets

  • To support short-term cash flow needs or fund new investment

Evaluating raising finance by selling unwanted assets

Sale and leaseback of non-current assets

• A non-current asset is an interchangeable term with fixed asset

• A sale and leaseback arrangement may be made if a business wants to continue to use an asset but needs cash

  • The business sells an asset, such as a building, for which it receives cash

  • The business then rents the asset from the new owners or a specialist leasing company

    • E.g. in early 2023, Sainsbury’s announced that it was in talks to sell some of its prime retail property for £500m, which it would then lease back from the new owners, LXi Reit

Evaluating sale and leaseback of non-current assets

Working capital

• Working capital is the money a business has available for day-to-day operations, such as paying wages, suppliers, and utility bills

• A business can adjust the way it manages working capital to free up cash and improve its short-term financial position without needing to borrow money

  • Delaying payment to suppliers gives the business more time to hold onto cash

  • Reducing stock levels means less money is tied up in unsold goods

  • Speeding up payments from customers brings in cash more quickly

  • Using existing cash reserves to cover expenses

Evaluating working capital as a source of finance

• Further notes on managing working capital can be reviewed here

Internal sources of finance and business ownership

• The type of business ownership, such as a sole trader, partnership, or limited company, can influence which internal sources of finance are available and suitable

  • Sole traders and partnerships tend to rely more on owner’s investment and working capital because they often have limited retained profit and fewer fixed assets to sell

• Companies are more likely to use retained profit, sale of fixed assets, or sale and leaseback, as they operate on a larger scale and have more internal resources