2-1-1-internal-finance

Introduction to sources of finance

• All businesses need finance to get started, allow them to grow and fund their continuing activity 

• Finance may be needed for capital expenditure, which is spending on fixed assets such as equipment, buildings, IT equipment and vehicles

• Similarly, finance is required for revenue expenditure, which is spending on raw materials or day-to-day expenses, such as wages or utilities 

• 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

Sources of internal finance

• Internal finance comes from the owner’s capital, retained profit or the sale of assets

Owner’s capital: personal savings

• Personal savings are a key source of funds when a business starts up

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

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

Retained profit

• The profit that has been generated in previous years and not distributed to owners is reinvested into the business

• This is a cheap source of finance, as it does not involve borrowing and the 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 investment

Sale of assets

• Selling business assets that are no longer required (e.g. machinery, land, buildings) generates a source of finance

• 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 (most likely a building) for which it receives cash

  • The business then rents the premises from the new owners

  • E.g. in early 2023, Sainsbury’s announced that it was in talks to sell its prime retail property for £500 million, which would then be leased back to the business by the new owners, LXi Reit

• A business can also generate additional finance internally by managing its working capital more effectively

  • It can negotiate extended payment terms with suppliers

  • It can encourage customers to pay more promptly for credit purchases

Advantages and disadvantages of using internal finance