the appropriateness of each possible source in a given situation

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5.2 Sources of Finance – Selecting the Most Appropriate Source

Learning Objective

To evaluate every possible source of finance for a given business situation, justify the most appropriate choice, and link each source to the relevant type(s) of business ownership.

5.2.1 Business Ownership ↔ Sources of Finance

Different ownership structures have legal and practical rights to particular finance options. Understanding *why* a source is or isn’t available is as important as knowing *which* sources exist.

  • Sole trader – can use personal savings, retained earnings, trade credit, bank overdraft/loan, micro‑finance, sale of assets, but cannot issue shares because there is no separate legal entity.
  • Partnership – similar to a sole trader; can obtain bank loans, overdrafts, trade credit and sell assets, but share issues are not possible unless the partnership is incorporated.
  • Private limited company (Ltd) – a separate legal entity; can use all internal sources, bank facilities, hire‑purchase, leasing, sale‑and‑lease‑back, equity share issues, venture capital, angel investors, government grants, crowd‑funding, etc.
  • Public limited company (PLC) – can also raise finance from the public markets (share issues, bonds) and attract large institutional investors.
  • Co‑operative / Social enterprise – can access member shares, grants, ethical‑funding schemes, and the same external facilities as Ltds.
  • Public‑sector / Government‑owned enterprise – may obtain funding directly from the Treasury, special government loans, or public‑sector bonds; they rarely use equity‑share issues because ownership is already public.

5.2.2 Internal vs. External Sources of Finance

Internal sources are generated within the business and do not create a liability on the balance sheet.

  • Retained earnings / profits – increases equity, no interest cost.
  • Sale of unwanted assets – one‑off cash inflow, no ongoing repayment.

External sources involve a third party and create a liability (debt) or dilute ownership (equity).

  • Bank loan, overdraft, hire‑purchase, leasing, sale‑and‑lease‑back – recorded as liabilities (or both asset & liability for HP).
  • Equity share issue, venture capital, angel investors, crowd‑funding (equity‑based) – recorded as share capital; ownership percentages change.
  • Government grants, subsidies – recorded as non‑repayable income; may have compliance conditions.

5.2.3 Official Factors Affecting the Choice of Finance (Cambridge Specification)

When evaluating a source, comment on each factor using the wording the exam expects.

  1. Cost – the total monetary charge (interest rate, dividend expectation, fees, or opportunity cost of using retained earnings).
  2. Flexibility – the ability to vary repayment dates, refinance, or withdraw funds without heavy penalties.
  3. Need to Retain Control – impact on ownership, voting rights, board representation, and any restrictive covenants.
  4. Use of Funds – suitability of the source for the specific purpose (capital asset, working capital, R&D, etc.).
  5. Existing Debt Levels – how much additional borrowing the business can reasonably support (debt‑to‑equity, interest‑covering ratio, covenant limits).

5.2.4 Mapping Factors to Detailed Evaluation Criteria

Criterion What to Assess Corresponding Official Factor
Cost (interest, dividend, fees) Effective annual rate, hidden charges, opportunity cost of retained earnings Cost
Control Impact Ownership dilution, voting rights, covenants, board seats Need to Retain Control
Risk & Repayment Obligation Fixed vs variable repayments, asset security, insolvency risk Existing Debt Levels
Availability & Speed Time to obtain funds, likelihood of approval, documentation required Flexibility (also influences Cost)
Fit for Purpose Whether the source is appropriate for capital expenditure, working‑capital, research, etc. Use of Funds

5.2.5 Decision‑Making Process (Step‑by‑Step)

  1. Identify the financing need – amount, purpose, time‑horizon, cash‑flow impact.
  2. List every viable source – use the comprehensive table (see 5.2.6) to ensure none are omitted.
  3. Apply the five official factors – write a brief comment for each source against each factor.
  4. Quantify where possible – calculate total cost of borrowing, effect on key ratios (debt‑to‑equity, current ratio, interest‑covering ratio).
  5. Use a weighted scoring model (optional) – assign weights to the five factors based on the business’s priorities, score each source, and total the points.
  6. Analyse the impact on the financial statements – forecast profit & loss, cash‑flow and balance‑sheet changes.
  7. Consider non‑financial issues – market perception, legal constraints, strategic fit, sustainability, ethical considerations.
  8. Select the most appropriate source (or mix) and write a justification that covers both quantitative data and qualitative reasoning.

5.2.6 Comprehensive Source‑Comparison Table

Sources are grouped into internal and external categories for quick reference.

Source of Finance Internal / External Applicable Ownership Types Typical Cost Control Impact Risk Level Availability / Speed Typical Use
Retained Earnings / Profits Internal All (sole trader, partnership, Ltd, PLC, Co‑op, Social enterprise, Public sector) Opportunity cost only (≈ 0 % interest) No dilution of ownership Very low Immediate Working capital, small expansions
Sale of Unwanted Assets Internal All ownership types One‑off cash inflow; no interest No ownership change Very low Weeks‑to‑months (finding buyer) Specific projects, debt reduction
Trade Credit (supplier financing) External Sole trader, Partnership, Ltd, PLC Usually 0 % if paid within terms; interest/penalties if late No ownership change Low‑to‑medium (depends on supplier relationship) Immediate once terms are agreed Short‑term working‑capital gaps
Bank Overdraft External Sole trader, Partnership, Ltd, PLC Variable 8 %–15 % on amount used No ownership change Medium – short‑term liability Immediate once approved Seasonal cash‑flow gaps
Bank Term Loan External Ltd, PLC, Co‑op, Joint venture, Social enterprise, Public sector Fixed/variable 5 %–12 % p.a. No ownership change (covenants may apply) Medium – fixed repayment obligations 1–3 months (credit assessment) Plant, equipment, long‑term projects
Hire‑Purchase External All (especially Ltd, PLC, Co‑op) Effective interest 6 %–12 % p.a. No ownership until final payment Low‑to‑medium (fixed instalments) 2–4 weeks Machinery, vehicles, IT equipment
Operating Lease External All ownership types Effective cost 5 %–10 % p.a. No ownership dilution Low‑to‑medium Weeks to months Equipment that may become obsolete
Sale‑and‑Lease‑Back External Ltd, PLC, Co‑op, Public sector Lease rate 6 %–10 % (effective) No ownership change (asset sold) Low‑to‑medium (lease obligation) 4–8 weeks Free up cash tied in fixed assets
Equity Share Issue (new ordinary shares) External Ltd, PLC (public), Co‑op (member shares) Dividend expectation 2 %–6 % (implicit) Ownership dilution; possible loss of control Low financial risk (no fixed repayments) 6–12 months (regulatory approval) Large expansions, R&D, acquisitions
Venture Capital External Ltd, PLC, Joint venture, Social enterprise (high‑growth) Equity stake demanding >20 % return Significant influence; board seats Medium – equity risk, exit pressure 3–6 months Start‑ups, innovative projects
Angel Investors External Ltd, PLC, Joint venture, Social enterprise Equity return 15 %–30 % Ownership dilution; mentorship possible Medium 1–3 months Early‑stage growth, product development
Government Grants / Subsidies External All, especially Ltd, PLC, Co‑op, Social enterprise, Public sector Usually 0 % (non‑repayable) No ownership change Very low (subject to compliance) 3–9 months (application & approval) Research, sustainability, regional development
Crowd‑Funding (reward‑ or equity‑based) External Ltd, PLC, Social enterprise, Start‑ups Platform fees 5 %–12 %; no interest if reward‑based Limited dilution (equity) or none (reward) Low‑to‑medium (depends on model) Weeks to months Product launches, community projects
Micro‑Finance / Community Development Loans External Sole trader, Partnership, Small Ltd Higher interest 12 %–20 % p.a. No ownership change Medium – repayment required 1–2 months Start‑up costs, inventory, modest expansion

5.2.7 Example Scenario – Applying the Process

Situation: A mid‑size manufacturing Ltd needs £2 million to purchase new CNC machines. It has £500 k of retained earnings, a good credit rating and currently carries £1 million of long‑term debt (debt‑to‑equity = 0.5).

  1. Financing need: £2 million, capital‑asset purchase, 5‑year useful life, expected cash‑flow increase £600 k per year.
  2. Possible sources: Retained earnings, bank term loan, hire‑purchase, operating lease, sale‑and‑lease‑back, government R&D grant, equity share issue.
  3. Factor analysis (summary):
Source Cost Flexibility Control Fit for Use Impact on Existing Debt
Retained Earnings (£500 k) Zero interest (opportunity cost only) Fully flexible – can be used at any time No dilution Can fund part of the purchase Reduces cash reserves; debt ratio unchanged
Bank Term Loan (£1.5 m, 7 % p.a., 5 yr) Fixed 7 % → total interest £262 k Standard amortisation; early repayment allowed with penalty No ownership change Ideal for long‑term capital asset Debt rises to £2.5 m → debt‑to‑equity ≈ 0.71 (still acceptable)
Hire‑Purchase (5 yr, 8 % effective) Higher total cost (£320 k interest) Fixed instalments; ownership at end No dilution Works, but more expensive than a loan Liability recorded as both debt and asset; ratio similar to loan
Operating Lease (£250 k per year, 5 yr) £1.25 m total outflow – more expensive than loan Very flexible – asset can be returned No dilution Better for short‑term use; not ideal for ownership Operating lease – no impact on debt‑to‑equity
Sale‑and‑Lease‑Back (sell existing plant, lease back) Effective lease rate 6 % Immediate cash, later lease payments No dilution Useful if existing assets are under‑utilised Reduces current debt but adds lease liability
Government R&D Grant (£300 k, 0 %) Zero cost, but limited to R&D component Application takes ~4 months No dilution Covers only part of the project No effect on debt
Equity Share Issue (£1 m) Dividend expectation ~3 % Funds available after 6–12 months Dilutes existing shareholders (ownership falls from 100 % to 71 %) More than needed; not cost‑effective for modest expansion Debt ratio improves but control is lost

Decision & Justification: Combine retained earnings (£500 k) with a bank term loan (£1.5 m). This mix:

  • Minimises total cost (interest only on the loan).
  • Preserves full control – no ownership dilution.
  • Keeps the debt‑to‑equity ratio within a comfortable range (0.71).
  • Matches the repayment schedule with the projected cash‑flow increase.
  • Provides the cash quickly (loan approved within 2 months).

5.2.8 Exam‑Ready Checklist

  • Have I listed *all* possible sources, including less common ones (sale‑and‑lease‑back, crowd‑funding, grants, micro‑finance, etc.)?
  • Did I link each source to the type(s) of business ownership that can use it and explain *why* the link exists?
  • For each source, have I commented on the five official factors using the exact terminology (cost, flexibility, need to retain control, use of funds, existing debt levels)?
  • Have I quantified the cost (interest, dividend, fees) and shown the effect on at least one key ratio (e.g., debt‑to‑equity, interest‑covering ratio)?
  • Is the chosen source (or mix) justified with both quantitative data and qualitative reasoning (control, strategic fit, market perception, legal constraints)?
  • Did I consider any non‑financial influences such as sustainability, ethical considerations, or government policy?

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