Internal sources of finance are funds generated from within the business itself, allowing firms to fund operations, investments, or growth without external borrowing.
Definition of Internal Sources of Finance
Internal finance refers to money that is sourced from within the business, rather than borrowed from banks, issued as shares, or acquired through third parties. This type of finance is typically retained from previous activities or assets the firm already owns and controls.
It is especially important for small firms or newly established businesses with limited access to external capital markets. Internal finance is often viewed as a safer, more sustainable form of financing since it avoids the commitments and costs that come with loans or investor involvement.
Key Characteristics:
Generated within the business rather than through external creditors or investors.
No interest charges or formal repayment terms.
Typically less complex and quicker to access than external finance.
Often limited in size, making it more suitable for smaller or short-term needs.
Preserves independence and control for existing owners or shareholders.
Key Internal Sources of Finance
Retained Profits
Retained profit is the most common form of internal finance for established businesses. It refers to the portion of the business’s net earnings that is not distributed to shareholders as dividends, but instead is kept within the company to fund future activities.
The formula for calculating retained profit is:
Retained Profit = Net Profit - Dividends Paid
Where:
Net Profit is the business’s total profit after all expenses and taxes.
Dividends Paid is the amount distributed to shareholders.
For instance, if a company earns £500,000 in net profit and pays out £150,000 in dividends, the retained profit is £350,000.
Uses of Retained Profits:
Buying new equipment or machinery
Funding research and development
Expanding operations
Hiring additional staff
Launching new products or services
Advantages:
No interest or fees – lowers the overall cost of finance.
No repayment obligation – improves cash flow as no scheduled payments are required.
No dilution of ownership – shareholders maintain full control over the business.
Demonstrates financial strength – a business funding its own growth appears more stable and attractive to potential investors.
Disadvantages:
Only available to profitable firms – unprofitable companies have no retained earnings to draw upon.
Potential shareholder dissatisfaction – shareholders may expect dividends and feel disappointed if profits are retained instead.
May limit reinvestment elsewhere – tying funds up in the business could mean missing other investment opportunities with higher returns.
Over-reliance on internal funds can restrict flexibility and strategic agility.
Example: A mid-sized software company retains £200,000 of its annual profits to invest in developing a new mobile app, avoiding the need for a bank loan.
Sale of Assets
The sale of assets involves converting business-owned resources into cash. These can include physical items like vehicles, machinery, property, or non-physical assets such as intellectual property or surplus inventory.
This method is commonly used when businesses wish to raise money quickly without increasing debt levels. However, it’s typically a one-off solution and is only effective if the asset in question is no longer crucial to operations.
Advantages:
Immediate access to cash – can be a quick solution for short-term funding needs.
No interest or repayments – as with all internal finance, there's no future cost associated.
Improves efficiency – disposing of idle or underperforming assets can streamline operations.
Disadvantages:
Finite resource – assets can only be sold once.
May result in operational issues – selling essential or semi-essential assets can reduce productivity or capacity.
Assets may be sold at a loss – especially if sold quickly or under market value.
Does not provide ongoing finance – unlike other sources such as retained profits, this source does not regenerate.
Example: A manufacturing firm sells outdated equipment for £50,000 and uses the proceeds to upgrade its IT systems.
Note: Some businesses may engage in “sale and leaseback” arrangements – selling an asset and leasing it back – which allows continued use while releasing capital. However, this is often considered a hybrid of internal and external finance.
Personal Savings (for Small Businesses)
Personal savings refer to money that an entrepreneur or small business owner contributes to their business from their own personal funds. This is one of the most common internal sources of finance for startups or small enterprises.
It is especially significant during the startup phase, when the business may not have an operating history or collateral to attract external investment.
Advantages:
No cost of borrowing – no interest or fees payable.
Quick and flexible – immediate access and full control over how funds are used.
Demonstrates commitment – shows faith in the business, which can be reassuring to potential partners or lenders.
Disadvantages:
Personal financial risk – the owner stands to lose their own money if the business fails.
Limited by available funds – personal savings are finite and may not cover all business needs.
Stress and strain – blurs the line between personal and business finance, which can add emotional pressure.
Example: A sole trader invests £10,000 of their own savings to purchase initial inventory for their online clothing store.
Advantages of Internal Sources of Finance
The use of internal finance offers several benefits to businesses, especially when compared to external borrowing or equity financing.
No Interest or Repayment Obligations
One of the greatest advantages is that internal funds do not incur interest, making them cheaper in the long run.
There are no repayment schedules to follow, allowing businesses to use the funds without immediate pressure to return the capital.
This improves cash flow management, especially for businesses with seasonal income or volatile revenue.
Maintains Ownership and Control
Internal finance does not involve issuing shares or taking on partners, meaning the existing owners retain full control over strategic decisions.
This is particularly important for small business owners who value independence.
Avoiding ownership dilution also ensures that profits remain with current stakeholders.
More Flexible and Accessible
Internal finance can usually be accessed more quickly than external finance, which often involves time-consuming paperwork, credit checks, or approval processes.
Businesses can allocate funds as needed, without external restrictions or conditions.
Encourages Efficiency and Self-Reliance
Relying on internal funds encourages businesses to operate more efficiently, as they become more aware of their spending and capital allocation.
Encourages strategic planning and prioritisation of investments based on available resources.
Disadvantages of Internal Sources of Finance
Despite their benefits, internal sources of finance have limitations and risks that businesses need to consider carefully.
Limited Availability
Internal funds are often insufficient for large-scale investments like opening a new factory or acquiring another company.
The business may miss growth opportunities if it cannot secure additional funding from external sources.
Opportunity Cost
By using internal funds, businesses forego the opportunity to use those funds elsewhere, such as:
Paying dividends to shareholders
Investing in high-yield external ventures
Holding cash reserves for emergencies
This cost is not always visible but can significantly affect long-term growth.
Depletes Financial Reserves
Internal finance usually comes from cash reserves or profits. Using too much may leave the business vulnerable during tough times, such as economic downturns or periods of low sales.
Maintaining an adequate cash buffer is vital for financial resilience.
Potential for Operational Disruption
Selling assets to generate cash can undermine the business’s productive capacity, especially if decisions are made hastily.
Poorly considered sales can lead to higher replacement costs in the future.
Increased Risk for Business Owners
For small businesses and startups, using personal savings may jeopardise personal financial security.
If the business fails, owners might lose not only their income but also their personal assets or savings, potentially affecting their family and future prospects.
Summary of Key Concepts
Retained profits are accumulated earnings reinvested into the business. They're cost-effective and maintain control, but are only available if the business is profitable.
Sale of assets allows the business to release capital tied up in non-essential assets. While fast and cost-free, it may impair future operations.
Personal savings are commonly used in small businesses and startups. Though interest-free and flexible, they carry significant personal risk.
Advantages of internal finance:
No interest or repayment obligations
Maintains business control
Quick and flexible access
Encourages strategic discipline
Disadvantages of internal finance:
Limited in amount and may not suit large investments
Opportunity cost and depletion of reserves
Risk to business owners’ personal finances
Understanding internal sources of finance equips A-Level Business students to make informed decisions about how businesses manage their financial needs using resources they already possess. It is vital to evaluate both the short- and long-term implications of each internal source when applied in a real-world business context.
FAQ
Yes, internal sources of finance such as retained profit can be used for long-term investments like purchasing new premises or developing new product lines. However, their effectiveness depends on the size and consistency of the business’s profit levels. Larger firms with healthy profit margins may accumulate enough retained profit to fund major capital projects. Small businesses, on the other hand, may struggle to generate sufficient internal funds for large-scale investments and might need to combine internal sources with external finance.
A business might avoid using internal finance to preserve liquidity and financial flexibility. Retaining cash reserves can be essential for absorbing shocks, such as unexpected expenses or revenue shortfalls. Using retained profit might also lead to shareholder dissatisfaction if dividend payments are reduced. Additionally, selling assets could impair operations if the assets contribute to production or customer service. Businesses may also want to take advantage of low-interest rates externally and spread the financial risk through borrowing.
Internal sources such as personal savings are often essential for startups, especially when external finance is difficult to obtain due to a lack of trading history or collateral. However, they are usually limited in scale and may only be enough to cover early-stage costs like initial inventory, basic equipment, or setup expenses. Startups relying solely on internal finance may face cash flow problems or miss early growth opportunities, making it vital to carefully balance ambition with the funds available.
Using internal finance can improve certain financial ratios. For example, it avoids increasing liabilities, helping maintain a low gearing ratio and reducing financial risk. Profitability ratios may also improve as there are no interest expenses. However, liquidity ratios could worsen if large amounts of cash or retained profit are used without generating immediate returns. If a business sells current assets like inventory, it could negatively impact the current ratio, indicating weaker short-term financial health if not managed carefully.
In some cases, yes. While retained profit is generally positive, consistently high retained earnings without reinvestment or dividend distribution might suggest the business lacks a clear strategy or is being overly cautious. If management holds back profit unnecessarily, it could frustrate shareholders who expect returns or reduce the company’s efficiency by hoarding cash. Businesses need to strike a balance between retaining profit for growth and rewarding investors, ensuring funds are used in a way that supports long-term objectives.
Practice Questions
Analyse one advantage and one disadvantage to a small business of using personal savings as a source of finance. (6 marks)
Using personal savings allows a small business to access immediate funds without paying interest or surrendering control, making it a cost-effective and flexible source. This can help the owner respond quickly to opportunities or challenges. However, a key disadvantage is the financial risk to the owner, as the business failing could result in a personal financial loss. This risk may cause stress and limit the amount the owner is willing to invest, potentially restricting the business’s growth. Therefore, while personal savings provide independence, they carry a significant personal and financial burden for small business owners.
Assess whether retained profit is the best source of finance for a large business looking to expand. (10 marks)
Retained profit is a low-cost, internal source of finance that avoids interest charges and maintains full ownership, making it attractive for a large business seeking expansion. It also allows flexibility and fast access to funds. However, retained profit is only available if the business is highly profitable, and using it reduces the amount available for dividends, potentially frustrating shareholders. In some cases, retained profit may not be sufficient for major expansion projects, requiring supplementary funding. Ultimately, while retained profit is advantageous, its suitability depends on profit levels, shareholder expectations, and the scale of the expansion required.
