Reasons why businesses need finance

Businesses require finance for various purposes, from starting up to maintaining operations and growing. This funding helps cover costs and supports activities that drive success.

Purposes for which businesses seek finance

• Starting a new business - New ventures need initial capital for assets or to manage early cash flow issues, where income may not yet cover expenses.
• Covering day-to-day operations - Struggling businesses might need extra funds to pay running costs, especially if customers pay late, creating liquidity gaps.
• Supporting expansion - Finance can be used to purchase bigger facilities or equipment to increase capacity.
• Hiring staff - Funds are often required to recruit and pay employees with the necessary skills to aid business growth.
• Funding promotion - Businesses may need money for marketing efforts, expecting higher sales to recover the investment.

Internal and external sources of finance

Finance can come from within the business (internal) or from outside (external). Internal sources are often quicker and avoid interest payments, while external sources provide larger amounts when internal options are limited.

Internal sources

Internal sources are generated from the business's own resources, such as profits or assets. They are quick to access and involve no borrowing costs. Examples include owner's savings, retained profits, and selling unused items.

External sources

External sources are obtained from outside parties, like banks or investors. They may involve repayment with interest or sharing ownership, but are useful when internal funds are insufficient. Examples include bank loans, overdrafts, and issuing shares.

Different sources of finance available to businesses

There are various ways businesses can obtain finance, each with advantages and drawbacks. The choice depends on the business's situation, such as its size and needs.

Internal sources of finance

• Retained profit - Profits not distributed to owners but reinvested in the business after dividends are paid.
• Sale of assets - Selling items like old equipment or buildings to generate cash, though overdoing this can limit operations.
• Owner's capital - Personal funds invested by the owner to start or support the business, with the risk of loss if the venture fails.
• New partner - Bringing in a partner who adds capital, but this means sharing control and future profits.

External sources of finance

• Overdrafts - Allow withdrawing more than the account balance to cover short-term needs, but with high interest and the risk of cancellation or asset seizure if unpaid.
• Loans - Borrowed sums from banks or family, repaid with interest; easier from informal sources but banks may demand profit shares or assets as security.
• Mortgages - Long-term loans for property purchases, using the property as security; low interest but risk of losing the asset if repayments fail.
• Trade credit - Suppliers allow delayed payment (e.g., up to eight weeks) without interest, helping cash flow by enabling sales before payment, though late fees apply.
• Share issue - Limited companies sell shares for funds without repayment, but this dilutes control and requires dividend payments to shareholders.
• Crowdfunding - Many individuals contribute small amounts online, often for innovative ideas; no repayment needed, but rewards and updates to backers can be costly and time-intensive.

Factors affecting the choice of finance

Several elements influence which source of finance a business selects, ensuring it matches the company's circumstances and minimises risks.

Influences on selecting finance sources

• Business stage (new or established) - Established businesses can use retained profits or sell assets more easily and are seen as less risky for loans, while new ones often lack these options and face higher scrutiny from lenders.
• Company type - Limited companies can issue shares publicly (public limited) or with agreement (private limited), unlike sole traders or partnerships.
• Amount required - Small sums often come internally, but large needs, like new equipment, typically require external funding.
• Duration needed - Short-term gaps suit overdrafts or savings, while long-term projects need loans or mortgages.
• Overall cost - Options like loans involve interest, making them more expensive than interest-free internal sources.