A business needs finance to operate, grow, and achieve its objectives, and understanding sources of finance is essential for making effective financial decisions.
What Are Sources of Finance?
Sources of finance are the means by which a business obtains funds to cover costs, make investments, and sustain operations. These funds can come from inside the business (internal) or from outside entities (external). Choosing the correct source is critical to a business’s short- and long-term success.
There is no one-size-fits-all source, and understanding the nature, advantages, and limitations of each type helps businesses remain financially stable and strategic in their decision-making.
Key Classifications
Finance sources are categorised into:
Internal and External finance
Short-term and Long-term finance
Each category addresses different business needs, and many sources may overlap across classifications depending on how they are used.
Internal vs External Sources of Finance
Internal Sources of Finance
Internal finance refers to money generated from within the business. This could be cash generated from day-to-day operations or the sale of business assets. These sources do not involve borrowing or the introduction of external investors.
Examples of internal sources:
Retained profit – Profits from previous years that are not distributed to shareholders but instead kept in the business for reinvestment.
Sale of assets – Selling off underutilised or obsolete assets like vehicles, equipment, or property to generate capital.
Owner’s personal savings – In sole proprietorships or partnerships, the owners may inject their own money into the business, especially in the early stages.
Advantages of internal finance:
No interest or repayment obligations, meaning it is cost-effective.
No dilution of ownership, as no new shareholders or external parties are involved.
Quick access in some cases, especially when using retained profit or savings.
Disadvantages of internal finance:
Often limited in amount—a business can only spend what it has generated or saved.
Using retained profit could limit growth, especially if large reserves are depleted.
Selling fixed assets may reduce operational capacity if they are still useful to some extent.
External Sources of Finance
External finance is obtained from outside the business and typically involves either borrowing money or exchanging ownership for investment. External finance is often used for large expenditures or when internal funds are insufficient.
Examples of external sources:
Overdrafts – Provided by banks, allowing businesses to withdraw more money than is in their account, usually with high interest rates. Used for very short-term cash shortfalls.
Bank loans – Fixed amounts borrowed over a specific term (e.g., 1, 5, or 10 years), repaid in instalments with interest.
Share capital – Money raised by issuing new shares to investors. This dilutes existing ownership but does not require repayment.
Venture capital – Investment from specialised firms or individuals who provide capital in exchange for equity and some level of control or influence.
Debt factoring – Selling unpaid customer invoices to a factoring company for immediate cash, often at a discount.
Crowdfunding – Collecting small amounts of money from a large number of people, typically through online platforms. Often used for start-ups or innovative projects.
Advantages of external finance:
Enables access to larger funds than internal sources may allow.
Spreads risk in the case of equity finance, where loss is shared with shareholders.
Can be tailored to long- or short-term needs with various financial products available.
Disadvantages of external finance:
Interest costs and fees can make borrowing expensive.
Loss of control may occur if equity is sold.
Some forms require collateral or strong credit ratings.
Application processes can be time-consuming and restrictive.
Short-Term vs Long-Term Sources of Finance
Short-Term Finance
Short-term finance refers to funds that are borrowed or used for a period typically less than one year. This type of finance is aimed at resolving temporary cash shortages or funding operational expenses.
Common uses of short-term finance:
Paying suppliers
Managing temporary cash flow issues
Covering seasonal expenses like inventory for peak demand periods
Examples of short-term sources:
Bank overdrafts – Immediate cash access but with high interest rates and possible penalties if exceeded.
Trade credit – Arrangements with suppliers to pay for goods or services at a later date, usually 30-90 days.
Debt factoring – Speeds up cash flow by selling receivables.
Credit cards – Fast and convenient but often costly due to high interest.
Benefits of short-term finance:
Quick access to funds.
Flexible repayment options (especially overdrafts).
Helps manage cash cycles.
Drawbacks:
Higher cost over time if not repaid quickly.
May strain relationships with suppliers if trade credit is mismanaged.
Could increase dependency on external help for basic operations.
Long-Term Finance
Long-term finance is designed for expenditures that provide benefits over many years, typically longer than 12 months. This type of finance supports strategic decisions and investments.
Common uses of long-term finance:
Purchasing land or buildings
Investing in major equipment or machinery
Business expansion (e.g., entering new markets or launching new products)
Examples of long-term sources:
Bank loans (long-term)
Share capital
Venture capital
Retained profits
Benefits of long-term finance:
Enables strategic planning and capital investment.
Can provide substantial funding over longer periods.
Repayment schedules are often more manageable.
Drawbacks:
Often involves complex approval processes.
May require strong credit history or security (collateral).
Long-term interest obligations or permanent ownership dilution.
Choosing the Right Source of Finance
The appropriateness of a financial source depends on multiple variables. There is no universally best option—each business must evaluate its circumstances and objectives carefully.
1. Purpose of the Finance
The reason behind needing finance is one of the most important factors.
Short-term need: Covering payroll, purchasing raw materials.
Suggested sources: overdrafts, trade credit.
Long-term need: Buying property, funding R&D.
Suggested sources: bank loans, share capital.
2. Time Frame
Businesses must match the duration of the need with the length of the finance.
Using a short-term overdraft for a five-year investment is risky and inappropriate.
Using long-term equity to pay a month’s utility bill is inefficient.
3. Cost Considerations
Businesses should compare the total cost of each finance option, including:
Interest payments
Set-up fees
Opportunity costs
For example:
A £50,000 loan at 6% interest over 3 years costs:
Annual interest = £50,000 * 0.06 = £3,000
Total interest over 3 years = £9,000
Retained profit costs nothing directly, but the business may miss out on alternative investment opportunities.
4. Ownership and Control
Some forms of finance involve sharing ownership, which affects control and decision-making.
Equity finance (e.g. share capital): Ownership is diluted; shareholders have voting rights.
Debt finance (e.g. loans): Ownership is maintained; however, repayments are compulsory.
Start-ups might prefer equity to avoid the burden of repayment, while established businesses may use debt to avoid losing control.
5. Business Size and Financial Position
Large firms with strong track records can access a wide range of finance options and often negotiate better terms.
Small firms or start-ups may struggle to obtain loans without a trading history or assets for collateral.
Sole traders and partnerships may rely heavily on personal savings, family and friends, or crowdfunding.
6. Risk Tolerance
Firms must assess how much risk they are willing to take on.
High-risk tolerance: May accept equity investment or large loans for rapid expansion.
Low-risk tolerance: Might prefer organic growth using retained profits.
Poor financial choices increase the risk of cash flow problems, defaults, and even insolvency.
Categorisation of Sources of Finance
Although this content would typically be best visualised in a table, here is a text-based categorisation of key finance sources by both origin (internal or external) and duration (short-term or long-term):
Internal, Short-Term
Typically, no significant sources fall under this category, as internal funds are usually used for long-term planning.
Internal, Long-Term
Retained profit – Using profits instead of distributing to shareholders.
Sale of assets – Selling equipment, vehicles, or property.
Owner’s personal savings – Especially for sole traders and new businesses.
External, Short-Term
Bank overdrafts – To handle temporary cash shortages.
Trade credit – Delaying payment to suppliers.
Credit cards – Immediate access with high flexibility.
Debt factoring – Turning invoices into instant cash.
External, Long-Term
Bank loans (term loans) – Fixed interest and repayment terms.
Share capital – Issuing new shares for funds.
Venture capital – Investment from venture firms or individuals.
Crowdfunding – Online fundraising from a wide audience.
Key Takeaways for Evaluation and Application
When evaluating financial sources in real business contexts or AQA exam scenarios, students should consider the following core decision-making criteria:
Time frame – Match source duration with use.
Cost – Include interest, fees, and opportunity costs.
Risk – Financial and ownership risks.
Control – Impact on decision-making and governance.
Purpose – Operating vs investing activities.
Business circumstances – Size, stage, financial health.
Understanding and applying these classifications equips students with the tools needed to analyse real-world business cases and make informed recommendations in written responses.
FAQ
Yes, some sources of finance can be categorised as either short-term or long-term depending on their application. For instance, a bank loan could be taken out over six months (short-term) or ten years (long-term). Similarly, retained profit might be used to cover a temporary cash flow gap (short-term) or reinvested into new premises (long-term). The classification depends on the repayment or usage period, not just the type of finance. Always consider the context of use when categorising sources.
A profitable business might still need external finance for several reasons. Profit does not always equate to immediate cash availability—some profits may be tied up in credit sales or reinvested in stock. Large capital investments, such as acquiring new premises or entering new markets, may exceed available internal funds. Additionally, a business might use external finance to preserve internal reserves for future emergencies, or to take advantage of growth opportunities without draining working capital. Profitability improves access but doesn't eliminate financing needs.
A firm’s legal structure directly influences which sources of finance are available. Sole traders and partnerships typically have limited access to external finance, as they cannot issue shares and may lack collateral for large loans. Their borrowing relies heavily on personal creditworthiness. In contrast, private and public limited companies can raise finance by selling shares or attracting venture capital. They often appear more creditworthy and attract more investors due to limited liability and clearer governance structures. The broader the legal structure, the greater the access to formal financial markets.
Yes, although internal finance avoids interest and ownership dilution, over-reliance can be risky. Using too much retained profit may leave insufficient reserves to cover unexpected expenses or economic downturns. Selling valuable assets might reduce operational efficiency or capacity. For small firms, draining personal savings could impact the owner’s financial security. Also, internal funds may not be enough to support large-scale expansion, potentially limiting growth. A balanced approach that includes some external finance can help manage risk and maintain liquidity.
Timing is crucial in selecting an appropriate source of finance. If a business needs funds urgently, it might opt for fast-access options like an overdraft or credit card, despite higher costs. Conversely, if planning a long-term investment, it can afford the time to negotiate a loan or issue equity, which may offer better terms. Timing also affects interest rates—short-term borrowing is often costlier per month but may be more manageable for brief needs. Businesses must align the timing of their financial need with the speed and suitability of funding access.
Practice Questions
Explain the difference between internal and external sources of finance, using examples. (6 marks)
Internal sources of finance are funds generated within the business, such as retained profit or the sale of existing assets. These do not require repayment and do not affect ownership. For example, a firm reinvesting last year’s profit to buy new machinery is using an internal source. In contrast, external sources involve funds from outside the business, such as bank loans or issuing shares. These usually involve either interest payments or ownership dilution. For instance, a business borrowing £50,000 from a bank to finance expansion is using an external source. Each type has different costs and implications for control.
Analyse why a business’s choice of finance depends on factors such as purpose, cost, and business context. (10 marks)
A business must carefully match its source of finance with its intended use. For example, short-term needs like paying suppliers are better suited to overdrafts, while long-term investments require sources such as loans or share capital. Cost is a key factor—using retained profit avoids interest, while loans incur regular repayments. Business context also matters: a start-up may struggle to get a bank loan due to lack of credit history and might instead use crowdfunding. Larger firms may prefer share capital to avoid repayments. Ultimately, the decision depends on balancing cost, risk, and how much control the business wants to retain.
