P4 Describe Sources of Internal and External Finance for a Selected Business

Task 1

There are two main ways that a business can access financial resources; internally or externally.

Internal sources of finance come from within the business, for example from the businesses owner’s savings or from profits.

External sources of finance come from outside the business and can be subdivided into long term and short term sources. Examples of long term sources are share capital and loan capital. Loan capital consists of mortgage, debentures, specialists and government. Share capital consists of ordinary shares, preference shares and deferred shares. Examples of short term sources are bank overdrafts, banks loans, hire purchases, trade credits, and leasing, factoring and trade bills.

Task 2

Short Term Sources (1-2 years)
Medium Term Sources (3-10 years)
Long Term Sources (Over 10 years)

Overdraft

Hire purchase

Mortgage
Retained profits

Ordinary share capital

Debenture

Trade credit

Leasing

Venture capital

Sale of assets

Bank loans

Retained profits

Owner’s capital/savings

Bank loans

Task 3

Source of Finance
Description
Advantages
Disadvantages
Owners Savings
When the owner uses his or her own savings to invest in the business. Usually a sole trader will start up a business with their own savings.
Interest does not have to be paid to someone else while the money is being used. The business is under their control.
There is a limit to the amount of money that the owner can invest.
Sale of Assets
When a business sells off fixed and current assets which it no longer needs in order to raise finance for new projects.
It is a quick and easy way to raise finance from stock that is no longer needed. Also, since the stock is being sold, it will no longer need to be stored and therefore all costs associated with this will be cut.
Since the stock is old and unsold, it is sold at a reduced price meaning the business will be getting less than the original price.
Retained Profit
Profit kept after all expenses and dividends are paid out. The profit left can be ‘ploughed back’ into the business for expansion purposes. It belongs to the business.
Even greater profits may be made in the future. There is nothing to be repaid. No interest is payable.
It is not available to a newly established business. The business may not actually make a big enough profit to ‘plough back’ in order to expand the business.
Overdraft
The bank allows a business to go ‘overdrawn’ up to an agreed amount. The business only pays interest on the amount overdrawn. The amount of interest paid is usually higher than a bank loan so caution is needed when using an overdraft. Usually used to pay small bills and expenses.
It is usually cheaper than a bank loan if used as a short term source. It is a good way to keep the business running during the period between money going out of and coming into the business.
Interest has to be paid on the amount overdrawn and can be expensive if used over a longer period of time.
Trade Credit
When suppliers give time to pay for supplies and stock – usually with a 30 day payment period. This can be difficult for sole traders to acquire in the early days.
The business can sell the stock and pay for it later (within 30 days) and if the money is paid back within the 30 days, no interest is charged.
The business needs to be careful with their money to ensure that they are able to pay the money back within the agreed time to avoid interest being charged. Discount given for cash payment would be lost.
Leasing
When an asset is used by a business but is never owned by the business. The business pays a monthly amount to use the asset and in return they have access to the latest equipment and support if the asset breaks or needs repair. Many businesses lease cars or computer equipment.
The business can have the access of up-to-date equipment (e.g. computers) immediately. Payments are made in instalments over a