Explain the main internal and external sources of finance, the difference between short-term and long-term finance, and the factors that influence the choice

What this dot point is asking

This outcome wants you to explain the main sources of finance - both internal (from within the firm) and external (from outside) - the difference between short-term and long-term finance, and the factors that influence which source a business chooses. The central idea is that the right source depends on what the money is for, how much is needed, the cost, and whether the owners are willing to take on debt or share ownership.

The answer

Internal sources of finance

Internal finance comes from within the business:

• Retained profit - profit kept back rather than paid to owners; cheap (no interest) but limited to what the firm has earned.
• Sale of assets - selling equipment or property no longer needed; raises cash but the firm loses the asset.
• Owner's savings - especially for a sole trader or partnership putting in their own money.

External sources of finance

External finance comes from outside the business:

• Bank loan - a lump sum repaid with interest over a set period; good for large, long-term needs.
• Overdraft - the bank lets the account go negative up to a limit; flexible and short-term but with high interest.
• Trade credit - paying suppliers later (for example in 30 days); a free short-term source.
• Share capital - selling shares to investors (for a company); large sums, no repayment, but ownership is shared.
• Government grants - money that need not be repaid, often with conditions.
• Leasing and hire purchase - using an asset while paying over time, rather than buying outright.

Short-term and long-term finance

• Short-term finance (overdraft, trade credit) covers day-to-day needs such as paying wages or buying stock. It is repaid quickly.
• Long-term finance (loans, share capital) funds large, lasting purchases such as buildings and machinery, repaid over years.

A key principle is matching: use long-term finance for long-term assets and short-term finance for short-term needs. Funding a factory with an overdraft would be a mistake.

Factors influencing the choice

The best source depends on:

• Purpose - a long-term asset needs long-term finance.
• Amount needed - large sums favour loans or shares; small sums an overdraft.
• Cost - interest on loans, the loss of profit share with new shares.
• Type and size of business - only companies can sell shares; banks lend more readily to established firms.
• Control - new shares dilute ownership; loans keep control but add debt and risk.
• Level of risk - too much borrowing (high gearing) is risky if profits fall.

Examples in context

Example 1. A start-up's first finance. A new Singapore food stall is funded by the owner's savings and a small bank loan, because as a sole trader he cannot sell shares and banks are cautious about lending much to an untested business. He uses trade credit from suppliers to ease early cash flow. This shows how a small new firm relies on owner's funds, a modest loan and trade credit, sources suited to its type and size.

Example 2. A company funding expansion. A profitable private limited company expands by combining retained profit (cheap, internal) with issuing more shares to invited investors to raise a large sum without taking on heavy debt. It avoids a huge loan that would mean large interest payments. The example shows how a company uses both internal funds and share capital for major long-term growth, balancing cost against sharing ownership.

Try this

Q1. Define the term internal finance. [2 marks]

• Cue. Internal finance is money raised from within the business itself, such as retained profit or the sale of unwanted assets, rather than from outside sources.

Q2. State two external sources of finance suitable for a limited company. [2 marks]

• Cue. Any two of: a bank loan, an overdraft, share capital (issuing shares), trade credit, leasing or hire purchase, and government grants.

Q3. Explain why a business should use long-term finance to buy a new factory rather than an overdraft. [4 marks]

• Cue. A factory is a large, long-term asset that will be used for many years, so it should be funded by finance repaid over a similar long period, such as a bank loan or shares. An overdraft is a short-term source that can be withdrawn by the bank at short notice and carries high interest, so using it for a major long-term purchase would be very risky and expensive, leaving the firm exposed if the overdraft were called in. Matching long-term finance to long-term assets keeps the firm financially stable.