Choosing the right source of finance is crucial for business success, affecting cost, control, flexibility, and long-term financial health. An informed decision ensures the business aligns financial strategy with operational goals and risk appetite.
Comparing Finance Sources
Each source of finance presents unique characteristics that influence its suitability. Students should compare them across four main criteria: cost, control, flexibility, and risk.
Cost: Interest and Fees
The financial cost of funding significantly impacts a business’s bottom line. Businesses must consider both direct and indirect costs.
Internal finance sources such as retained profits and sale of assets involve no interest or ongoing fees, making them low-cost options. However, they come with an opportunity cost—using cash now may reduce the ability to invest in other future opportunities.
Overdrafts are among the most expensive forms of borrowing due to their variable and high interest rates, which can change with little notice. They may also include additional arrangement or renewal fees, adding to overall cost.
Bank loans generally offer lower interest rates compared to overdrafts, particularly for businesses with good creditworthiness. However, loans often carry setup charges, and early repayment can sometimes result in penalties.
Share capital does not involve traditional interest payments. Instead, shareholders may expect dividends, which can reduce retained earnings. Although not obligatory, skipping dividends may lead to shareholder dissatisfaction.
Venture capital involves no interest, but venture capitalists often demand a significant return via equity ownership, meaning a share in future profits or exit gains.
Debt factoring reduces the value of sales revenue, as companies usually receive 80% to 90% of invoice value up front, with the factor charging fees and interest on the balance.
Crowdfunding platforms often charge a platform fee (e.g. 5%) and a payment processing fee (e.g. 3%). If a funding target is not reached, funds may not be collected depending on the model used.
Overall, internal finance is often cheapest but may not be available in large amounts. External sources vary widely in cost depending on the business’s credit risk and structure.
Control: Ownership and Decision-Making Power
Control is a vital issue, particularly for owner-managed firms. Loss of control can influence strategic decisions and business culture.
Internal finance maintains full ownership and decision-making authority, making it ideal for entrepreneurs wanting complete control.
Bank loans and overdrafts do not influence control, though loan agreements might include restrictive covenants that limit certain business actions (e.g. restrictions on further borrowing).
Share capital means issuing new shares—this dilutes ownership and reduces the original shareholders’ power. Shareholders have voting rights, potentially affecting strategic decisions.
Venture capital often results in significant loss of control, as investors may seek board representation, veto rights, or performance clauses.
Crowdfunding can also affect control depending on the model:
Reward-based: No ownership given.
Equity-based: Investors become shareholders, reducing control.
Debt-based: No impact on ownership.
Debt factoring doesn’t affect ownership but may impact customer relationships, indirectly influencing brand reputation and strategic flexibility.
Key takeaway: businesses prioritising control should avoid equity-based finance.
Flexibility
Flexibility refers to how easily and quickly a source of finance can be accessed, adjusted, or terminated to suit changing business needs.
Overdrafts are the most flexible source, allowing businesses to borrow up to an agreed limit and repay when convenient. Ideal for fluctuating cash flows.
Loans are less flexible due to fixed repayment schedules and possible penalties for early repayment or non-compliance.
Retained profits offer maximum freedom in terms of use and timing.
Sale of assets is inflexible—once an asset is sold, it is no longer available, and reacquiring it may be difficult or expensive.
Share capital and venture capital offer large sums without repayment, but the process of securing them is complex and time-consuming.
Debt factoring is flexible in terms of speed of access, but once invoices are sold, businesses lose control over those payments.
Crowdfunding involves considerable time and marketing effort, and its success is uncertain. Some platforms also use an “all-or-nothing” model, meaning funds are only collected if the target is met.
Risk: Financial and Operational
Different finance sources pose varying levels of risk to the business and its owners.
Bank loans and overdrafts increase financial risk due to the obligation to repay with interest. If the business underperforms, it may default, damaging its credit rating or triggering asset repossession (in case of secured loans).
Sale of assets may pose operational risk—selling essential equipment could impair output or quality.
Using retained profits can deplete cash reserves, leaving the business vulnerable to unexpected costs.
Venture capital and share capital can introduce strategic risk—new owners may push the business in a direction that doesn't align with original goals.
Debt factoring introduces reputational risk if the factor aggressively collects payment, potentially alienating customers.
Crowdfunding can create public perception risk. If a campaign fails, it may signal lack of market confidence, damaging future investor interest.
Best-Fit Sources Based on Use Case
Finance choices should match the business need. Below are common business situations and the most appropriate funding options for each.
Buying Equipment
Loans: A fixed-term loan matches the long-term nature of assets like machinery. Repayment terms can be tailored to cash flow and asset lifespan.
Retained profits: If reserves are available, this avoids interest and maintains full control.
Hire purchase (though not covered in depth): Spreads cost but includes interest; the business owns the asset only after final payment.
Share capital: For larger projects, especially for limited companies planning strategic upgrades.
Covering Cash Shortfalls
Overdrafts: Ideal for temporary gaps. They offer flexibility, immediate access, and easy repayment when funds arrive.
Debt factoring: Unlocks funds from unpaid invoices quickly, especially useful for firms with high credit sales.
Sale of assets: May provide immediate liquidity, but only appropriate if assets are non-essential.
Funding Expansion
Share capital: Well-suited for ambitious, long-term growth requiring substantial investment.
Venture capital: Offers both funding and business expertise, useful for scaling fast.
Retained profits: A good option if the business is cash-rich and wants to avoid debt.
Loans: Suitable for medium-sized expansions with predictable returns.
Crowdfunding: Offers capital and market exposure but depends on campaign success and public interest.
Decision-Making Scenarios
AQA exams may provide case studies where students must evaluate which finance source best fits a given business context.
Scenario 1: Small Bakery Needs £5,000 to Replace Ovens
Options:
Retained profits (if available)
Small loan
Overdraft
Best fit: Retained profits—avoids interest and doesn’t add to liabilities. If unavailable, a small loan offers structure and predictability.
It depends:
Cash reserves
Loan interest rate
Urgency of oven replacement
Scenario 2: Tech Start-up Requires £750,000 for Research and Development
Options:
Venture capital
Share capital
Equity-based crowdfunding
Best fit: Venture capital—brings expertise and large investment. Share capital also suits if the business structure allows.
It depends:
Desire to retain control
Investor appetite for risk
Forecasted growth and exit strategy
Scenario 3: Retailer Has £100,000 in Unpaid Invoices and Needs Immediate Cash
Options:
Overdraft
Debt factoring
Best fit: Debt factoring—provides immediate cash flow based on invoice value.
It depends:
Willingness to sacrifice a portion of income
Potential impact on customer relationships
Scenario 4: Clothing Brand Plans to Open a New Store
Options:
Long-term loan
Share capital
Retained profits
Best fit: Long-term loan—aligns with the long-term nature of the asset and provides structured funding.
It depends:
Cash reserves
Willingness to share ownership
Revenue forecasts for new store
Financial Criteria in Decision-Making
When choosing a source of finance, students must apply financial logic and assess the suitability using clear, measurable factors.
Cost
Total cost includes interest, arrangement fees, platform charges, and opportunity costs.
Lower cost options (e.g. retained profits) are preferable if available and do not compromise liquidity.
Repayment Period
Match the loan term to the life of the asset. For example:
Equipment expected to last 5 years should be funded with a 5-year loan.
Avoid funding long-term investments with short-term borrowing, which could create cash flow issues.
Return on Investment (ROI)
Calculate ROI using:
ROI (%) = (Return from Investment - Cost of Investment) ÷ Cost of Investment × 100
Choose finance that supports projects with ROI greater than the cost of borrowing.
For example, if a loan has 8% interest and the project generates 15% return, the finance decision is justifiable.
Exam-Style Evaluative Framework
In AQA exams, students should apply analytical and evaluative reasoning, showing how their decision changes based on circumstances.
Structure for Evaluation
Identify potential options
Compare pros and cons using key criteria
Use “it depends” to introduce contingencies
Justify your recommendation based on business context
“It Depends” Factors
Business size and structure: Sole traders can’t issue shares; limited companies have broader options.
Stage of growth: Start-ups may lack retained profits and credit history; established firms can access more traditional finance.
Risk appetite: Conservative businesses may prefer internal finance or loans; high-growth firms may accept loss of control for capital.
Cash flow reliability: Firms with steady income can afford regular loan repayments; volatile cash flow may require flexible finance.
Strategic goals: Ambitious expansion may require external investors; lifestyle businesses may prefer control and low risk.
By systematically evaluating the cost, control, flexibility, and risk of each option, students can develop sophisticated, exam-ready responses that match real-world financial decision-making.
FAQ
A business with high profits might opt for external finance to preserve cash reserves for unforeseen expenses or investment flexibility. Internal finance, such as retained profits, depletes the company’s safety net and may hinder future agility. External finance also allows businesses to spread the cost of investment over time, supporting better cash flow management. Furthermore, using external sources like loans or equity can offer strategic benefits, such as investor expertise or leveraging low-interest market conditions without immediately reducing retained earnings.
Frequent or large use of external finance, especially loans and overdrafts, directly influences a business's credit rating. Timely repayments improve creditworthiness, enabling access to lower-cost borrowing in the future. However, missed repayments or heavy reliance on short-term borrowing may damage the credit score, limiting future options. Unlike loans, issuing share capital or using retained profits doesn’t affect credit ratings but may change financial ratios used by lenders, indirectly influencing how banks view a firm’s financial stability.
Investor confidence is critical for raising finance through crowdfunding and share capital. For crowdfunding, especially equity-based models, potential backers assess the business plan, past performance, and perceived credibility before committing funds. A lack of transparency or poor marketing can result in campaign failure. For share capital, especially in public limited companies, falling investor confidence may lead to undervalued share prices and poor capital raising ability. Positive business reputation, strong leadership, and growth potential are key to maintaining high investor confidence.
The legal structure directly affects what finance options are legally and practically available. Sole traders and partnerships cannot issue shares, limiting them to internal funds, loans, overdrafts, or personal savings. Limited companies can raise finance through share capital and venture capital, opening up access to equity-based funding. Public limited companies (PLCs) have even greater access through stock markets. Lenders may also offer better terms to incorporated businesses due to limited liability and greater financial disclosure obligations.
Yes, businesses often combine multiple finance sources—known as a blended finance strategy—to reduce reliance on a single funding stream and spread risk. For example, a firm might use retained profits alongside a bank loan to fund expansion. This reduces borrowing requirements and interest costs. However, risks include increased complexity in repayment obligations, potential dilution of control if equity is involved, and difficulty in coordinating different terms and conditions. A poorly structured mix may harm cash flow or strategic flexibility.
Practice Questions
Analyse the factors a business should consider when choosing between a bank loan and share capital to fund expansion. (10 marks)
When deciding between a bank loan and share capital, a business must assess control, cost, and financial stability. A loan maintains full ownership but involves regular repayments and interest, increasing financial risk. Share capital involves no repayment but dilutes ownership and may reduce decision-making power. If the business has stable cash flow and wishes to retain control, a loan may be suitable. However, if rapid growth is needed and the owner is willing to share control, share capital may be better. The decision ultimately depends on the firm's goals, risk tolerance, and current financial position.
Evaluate whether a small retail business should use debt factoring or an overdraft to manage short-term cash flow issues. (12 marks)
Debt factoring provides quick access to cash by selling invoices but reduces revenue and may harm customer relationships. An overdraft is flexible and preserves customer contact, but high interest makes it costly. A small retail business with strong customer loyalty might avoid factoring to protect its reputation. However, if invoices are large and overdue, factoring gives immediate liquidity. If cash flow problems are short-term and sales are steady, an overdraft may be preferable despite cost. The best choice depends on the urgency of cash needs, customer relationship importance, and the cost and availability of both options.
