recommend and justify an appropriate source of finance for a given situation

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5.1.2 The Main Sources of Finance

Learning objective

Students will be able to recommend and justify an appropriate source of finance for a given business situation, using relevant quantitative and qualitative information.

Why businesses need finance

  • Start‑up finance – launching a new venture.
  • Asset finance – buying machinery, vehicles, premises, IT equipment.
  • Working‑capital finance – covering stock, receivables, cash‑flow gaps.
  • Growth finance – expanding product lines, entering new markets, acquisitions.
  • Contingency finance – unexpected costs, emergencies, seasonal fluctuations.

Short‑term vs long‑term finance

Classification is based on the period over which the money is required or must be repaid.

Finance type Typical term Typical uses Examples
Short‑term finance Up to 12 months (often 30–90 days) Working‑capital, seasonal stock, bridging cash‑flow gaps Overdraft, trade credit, short‑term bank loan, factoring, hire‑purchase (initial period)
Long‑term finance More than 12 months – usually several years Asset purchase, major expansion, start‑up capital, research & development Long‑term bank loan, lease, debenture, share issue, venture‑capital, government grant, mortgage

Sources of finance

1. Internal (owner’s) sources

  • Retained profits / reserves – profit kept in the business rather than distributed.
  • Sale of non‑essential assets – e.g., surplus land, obsolete equipment.
  • Owner’s personal savings or capital contribution – common in start‑ups.

2. External sources

Bank finance
  • Short‑term loan – fixed amount, repayment usually within 12 months.
  • Long‑term loan – repayment over 5–20 years, often secured against assets.
  • Overdraft – revolving credit facility linked to the current account.
Trade credit

Supplier allows payment at a later date (normally 30–90 days). May include cash‑discounts for early payment.

Hire purchase / finance lease
  • Asset paid for in instalments; ownership transfers only after the final payment (hire purchase).
  • Finance lease – business uses the asset for an agreed period without acquiring ownership.
Equity finance
  • Share issue – private (family, friends) or public (stock exchange).
  • Venture capital – professional investors provide capital for high‑growth businesses.
  • Angel investors – wealthy individuals offering capital and expertise.
Government finance
  • Grants – non‑repayable cash for specific projects (e.g., innovation, training).
  • Subsidies & tax‑relief schemes – reduce the cost of finance or operating expenses.
Alternative finance
  • Micro‑finance – small loans for start‑ups or very small firms, usually at higher rates.
  • Crowd‑funding – online platforms; reward‑based (pre‑sell product) or equity‑based.
  • Factoring – selling receivables to a third party for immediate cash.

Comparison of the main sources

Source Internal / External Typical term Control impact Cost (interest / dividend / fees) Risk to business
Retained profits Internal Indefinite No loss of control Opportunity cost only Low
Bank loan – short‑term External ≤ 12 months No ownership dilution Fixed or variable interest Medium – repayment required
Bank loan – long‑term External 5–20 years No ownership dilution Usually lower fixed interest Medium – long‑term debt
Overdraft External Revolving, typically up to 12 months No ownership dilution Variable interest + arrangement fees High – facility can be withdrawn
Trade credit External 30–90 days (extendable) No ownership dilution Usually interest‑free; possible discount loss Low‑to‑medium – depends on supplier relationship
Hire purchase / lease External 2–5 years (lease may be longer) Ownership only after final payment (lease – no ownership) Interest + instalments Medium – asset tied up
Equity (share issue) External Indefinite Shares dilute control Dividends (if declared) + issue costs Low – no repayment obligation
Venture capital / angel investor External 5–10 years (usually) Significant dilution; possible board involvement Profit‑share, dividends, exit‑share Medium‑high – high growth expectations
Government grant External Project‑specific (1–3 years) No loss of control Usually none (may have reporting costs) Low – strict eligibility & reporting
Micro‑finance External 6 months – 3 years No ownership dilution Higher interest than mainstream banks Medium – small‑scale debt
Crowd‑funding (reward‑based) External Weeks–months (project‑specific) No ownership dilution Platform fee + reward costs Low – success not guaranteed

Key factors to consider when choosing a source of finance

  • Amount required – can the source meet the full need?
  • Purpose of finance – working‑capital, asset purchase, start‑up, expansion?
  • Time‑frame – short‑term need vs long‑term investment.
  • Cost – interest rate, fees, dividend expectations, opportunity cost.
  • Control & ownership – will the source dilute the owner’s control?
  • Risk & security – collateral required? What if cash‑flow falls?
  • Availability & eligibility – credit rating, legal form, government criteria.
  • Flexibility – ability to vary repayments or increase the facility.
  • Reputation impact – e.g., a reputable bank may enhance credibility with suppliers.

Decision‑making process for selecting finance

  1. Identify the exact amount and purpose.
  2. Classify the need as short‑term or long‑term.
  3. Analyse the business’s current position – cash flow, assets, credit rating, legal structure.
  4. Short‑list suitable sources that meet the amount, term and eligibility.
  5. Calculate the total cost of each option (interest, fees, dividend, opportunity cost).
  6. Weigh non‑financial factors – control, risk, flexibility, reputation.
  7. Choose the most appropriate source and write a concise, evidence‑based justification.

Case‑study illustration

Situation: “TrendWear”, a small clothing retailer, expects a seasonal surge and needs £30 000 of new stock. The business has £10 000 of retained profit and a good relationship with its bank.

Possible sources:

  • Use the £10 000 retained profit and obtain a £20 000 overdraft.
  • Apply for a short‑term bank loan of £20 000 at 6 % p.a.
  • Negotiate trade credit for the full £30 000 (payable in 90 days).
  • Apply for a government grant for small‑retail stock replenishment (if eligible).

Recommendation

Trade credit for the full £30 000, supplemented by retained profit if cash is needed for other expenses.

Justification

  • Trade credit is interest‑free when paid within 90 days – the lowest financing cost.
  • Matches the short‑term, seasonal nature of the stock; sales will generate cash before the payment date.
  • Preserves cash flow, allowing the retained profit to cover day‑to‑day operating costs or act as a safety buffer.
  • No loss of ownership and no additional debt, reducing financial risk.
  • If the supplier cannot extend full credit, the next best option is a short‑term overdraft, which is more expensive and can be withdrawn.

Summary checklist for exam answers

  • State the amount and purpose of the finance required.
  • Classify the need as short‑term or long‑term.
  • Identify at least three possible sources and label each as internal or external.
  • Compare the sources using the key factors: cost, control, risk, time‑frame, availability.
  • Choose the most appropriate source and provide a concise, evidence‑based justification (refer to calculations where relevant).
Suggested diagram: Flowchart of the decision‑making process for selecting a source of finance (from “Identify need” to “Justify choice”).

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