2.1.1 Internal Finance
Types of internal finance:
Owner’s capital/personal savings – The personal savings of the business’s owner.
Retained profit – The profit that the business has made so far through trade.
Sale of assets – The sale of business assets such as machinery.
A) Owner’s capital
Benefits
No debt – By using owner’s capital as a source of finance it means that the business does not have to
take out any loans. As a result of this they will not have any debt that will need to be paid off.
Drawbacks
Limited funds available – The Capital that the owner has available to invest in the business is likely to
be limited. As a result of this, owner’s capital would be an unsuitable source of finance if the business
were looking at sources of finance for activities such as expansion which would require a much larger
amount of capital
B) Retained profit
Benefits
No debt – By using this source of finance it means that the business may not have to use loan capital.
As a result of this, no interest has to be paid. This will reduce the long term liabilities of the business
which will result in a lower gearing ratio.
Flexible – The amount of retained profit used to invest in the business is chosen by the owner. They
will also decide where to invest the profits which can be in contrast to some of the other types of
finance. Therefore, retained profit is a flexible source of finance.
Drawbacks
Reduce dividends for shareholders – By using retained profits to reinvest in the business it means
that there will be less profit left to give to shareholders. As a result of this, the dividends that they
receive will be lower. This may result in shareholders becoming unhappy. This is especially the case if
the return on capital employed is low meaning that the benefit of investment is limited (ROCE % =
Operating profit/Capital employed X 100).
Businesses with higher profit can afford debt – This is due to the fact that the business is likely to
have a relatively low gearing ratio. This is because high profits will mean that the business has a high
amount of capital employed (capital employed = Non-current assets +current assets – current
liabilities). Therefore, they can afford to increase their long-term liabilities through loaning money as
their gearing ratio will remain relatively low regardless meaning they will be able to pay for their loan
repayments.
Limited profits – Most businesses are unlikely to have the retained profit required in order to fund big
investments in their business e.g. expansion. Therefore, the source of finance is unlikely to be
suitable when making big investments in the business. This is especially the case for smaller
businesses that make small amounts of profit.
C) Sale of assets
, Benefits
Assets depreciate in value – By selling assets as a source of finance it means that the business will be
able to get the money from the assets before they depreciates in price.
Drawbacks
Lose benefit from the asset – By selling the asset it means that the business can no longer benefit
from the function of the asset. For example, if a business were to sell some machinery then it means
that the machinery could no longer be used to produce goods. Therefore, by selling assets it may
result in a decrease in productivity and therefore output if it is not replaced.
Sole Trader – A sole trader is likely to use owner’s capital as an internal source of financing. This is because they are
unlikely to be able to use retained profits as they are unlikely to have a substantial amount. Furthermore, they are
unlikely to have very many assets and therefore will not be able to raise sufficient funds. This is especially the case if the
business has just started up.
Partnership – A partnership may be able to use retained profit depending on how successful the business is.
Furthermore, they could also use sale of assets and owner’s capital.
LTD and PLC – Both types of business are most likely to use retained profits as they are likely to be much more profitable
than sole traders and partnerships. Therefore, it would be unnecessary for them to use owner’s capital. However, they
could use sale of assets as a means of raising finance. However, if the business is run efficiently than they are unlikely to
have a surplus of assets available to them that they can sell.
2.1.2 External finance
Types of internal finance:
Owner’s capital/personal savings – The personal savings of the business’s owner.
Retained profit – The profit that the business has made so far through trade.
Sale of assets – The sale of business assets such as machinery.
A) Owner’s capital
Benefits
No debt – By using owner’s capital as a source of finance it means that the business does not have to
take out any loans. As a result of this they will not have any debt that will need to be paid off.
Drawbacks
Limited funds available – The Capital that the owner has available to invest in the business is likely to
be limited. As a result of this, owner’s capital would be an unsuitable source of finance if the business
were looking at sources of finance for activities such as expansion which would require a much larger
amount of capital
B) Retained profit
Benefits
No debt – By using this source of finance it means that the business may not have to use loan capital.
As a result of this, no interest has to be paid. This will reduce the long term liabilities of the business
which will result in a lower gearing ratio.
Flexible – The amount of retained profit used to invest in the business is chosen by the owner. They
will also decide where to invest the profits which can be in contrast to some of the other types of
finance. Therefore, retained profit is a flexible source of finance.
Drawbacks
Reduce dividends for shareholders – By using retained profits to reinvest in the business it means
that there will be less profit left to give to shareholders. As a result of this, the dividends that they
receive will be lower. This may result in shareholders becoming unhappy. This is especially the case if
the return on capital employed is low meaning that the benefit of investment is limited (ROCE % =
Operating profit/Capital employed X 100).
Businesses with higher profit can afford debt – This is due to the fact that the business is likely to
have a relatively low gearing ratio. This is because high profits will mean that the business has a high
amount of capital employed (capital employed = Non-current assets +current assets – current
liabilities). Therefore, they can afford to increase their long-term liabilities through loaning money as
their gearing ratio will remain relatively low regardless meaning they will be able to pay for their loan
repayments.
Limited profits – Most businesses are unlikely to have the retained profit required in order to fund big
investments in their business e.g. expansion. Therefore, the source of finance is unlikely to be
suitable when making big investments in the business. This is especially the case for smaller
businesses that make small amounts of profit.
C) Sale of assets
, Benefits
Assets depreciate in value – By selling assets as a source of finance it means that the business will be
able to get the money from the assets before they depreciates in price.
Drawbacks
Lose benefit from the asset – By selling the asset it means that the business can no longer benefit
from the function of the asset. For example, if a business were to sell some machinery then it means
that the machinery could no longer be used to produce goods. Therefore, by selling assets it may
result in a decrease in productivity and therefore output if it is not replaced.
Sole Trader – A sole trader is likely to use owner’s capital as an internal source of financing. This is because they are
unlikely to be able to use retained profits as they are unlikely to have a substantial amount. Furthermore, they are
unlikely to have very many assets and therefore will not be able to raise sufficient funds. This is especially the case if the
business has just started up.
Partnership – A partnership may be able to use retained profit depending on how successful the business is.
Furthermore, they could also use sale of assets and owner’s capital.
LTD and PLC – Both types of business are most likely to use retained profits as they are likely to be much more profitable
than sole traders and partnerships. Therefore, it would be unnecessary for them to use owner’s capital. However, they
could use sale of assets as a means of raising finance. However, if the business is run efficiently than they are unlikely to
have a surplus of assets available to them that they can sell.
2.1.2 External finance
