Internal Sources of Finance
- Internal sources of finance are funds generated from within a business, offering a way to meet financial needs without relying on external parties.
- They are often the first choice for businesses seeking to maintain control and avoid debt.
Personal Funds (for Sole Traders)
Personal Funds
Personal funds are the owner's personal savings used to finance the business.
This is common for sole traders, who often rely on their own resources to start-up or sustain their ventures.
Start-up Capital
Capital that is required to start the business. It is the initial cost required to cover its early costs.
Why Use Personal Funds?
- Lack of external funding: Sole traders often use personal savings to launch their businesses, as external funding may be hard to secure.
- Demonstrating Commitment: Investing personal funds shows dedication, which can attract additional investors or lenders.
- Emergency Funding: Personal savings can be a lifeline during financial challenges, such as unexpected expenses or cash flow shortages.
A sole trader opening a small bakery might use personal savings to purchase equipment and ingredients. This reduces the need for loans and interest payments.
Advantages
- No Interest or Repayments: Unlike loans, personal funds don't incur interest or require repayment.
- Full Control: The owner retains complete control over the business without external interference.
- Quick Access: Personal funds are readily available, enabling swift decision-making.
Disadvantages
- Limited Availability: Personal savings may not be sufficient for large investments or long-term growth.
- Personal Risk: The owner's personal assets, such as savings or property, are at risk if the business fails.
- Opportunity Cost: Using personal funds means sacrificing other potential investments or savings.
Using personal funds can also build credibility with banks or investors, as it shows the owner's willingness to take financial risks for the business.
Retained Profit
Retained Profit
Retained profit is the portion of a business's earnings kept within the company instead of being distributed to shareholders or owners.
Why Use Retained Profit?
- Reinvestment: Businesses use retained profit to fund growth initiatives, such as expanding operations, purchasing new equipment, or launching new products.
- Debt Reduction: Retained profit can be used to pay off existing debts, improving the company's financial stability.
- Buffer for Uncertainty: It acts as a financial cushion during economic downturns or unexpected challenges.
A retail company might use retained profit to open a new store, avoiding the need for a loan and its associated interest costs.
Advantages
- No Interest or Debt: Retained profit is a cost-free source of finance, eliminating the need for loans or interest payments.
- Flexibility: The business can decide how and when to use the funds, without external constraints.
- Maintains Control: Using retained profit avoids diluting ownership or control, as would happen with issuing new shares.
Disadvantages
- Limited to Profitable Businesses: Only businesses with sufficient profits can rely on this source.
- Opportunity Cost: Retaining profit may disappoint shareholders who prefer higher dividends.
- Insufficient for Large Investments: Retained profit may not cover significant expenses, such as major acquisitions or infrastructure projects.
Remember retained profits are not always available, it depends on the business's profitability and past financial performance.
- Remember not to refer to 'Retained Profits' to businesses that are just started in the current year.
- Newly started businesses have no scope of retained profits.
Sale of Assets
Sale of assets
Sale of assets involves selling non-essential or underutilized assets to generate capital.
Why Sell Assets?
- Freeing Up Capital: Businesses can sell assets that are no longer needed or are underperforming.
- Funding Strategic Goals: The proceeds can be reinvested into areas with higher growth potential.
- Reducing expenses: Selling outdated or costly assets can reduce ongoing expenses.
A manufacturing company might sell unused machinery to invest in modern equipment or digital technology.
Advantages
- No Debt or Interest: Selling assets provides immediate cash without incurring debt.
- Improves Efficiency: Eliminating underutilised assets can streamline operations and reduce costs.
- Retains Ownership: Unlike external financing, selling assets doesn't dilute ownership or control.
Disadvantages
- Loss of Future Use: Once sold, the asset is no longer available, which may limit future flexibility.
- One-Time Solution: Asset sales provide a one-time cash injection and are not a sustainable long-term strategy.
- Potential Undervaluation: Assets may be sold at a lower price than their true value, especially in a rushed sale.
Consider sale and leaseback as an alternative. This allows the business to sell an asset and lease it back, retaining its use while accessing capital.
When Are Internal Sources Most Appropriate?
- Start-Ups and Small Businesses: Personal funds and retained profit are often the only viable options for new or small businesses with limited access to external finance.
- Avoiding Debt: Businesses that prioritize financial independence or have high existing debt may prefer internal sources.
- Short-Term Needs: Internal sources are ideal for funding short-term projects or bridging temporary cash flow gaps.
| Internal Source | Advantages | Disadvantages |
|---|---|---|
| Personal Funds | No interest or debt | Limited availability |
| Full control | Personal risk | |
| Quick access | Opportunity cost | |
| Retained Profit | Cost-free | Limited to profitable businesses |
| Flexible | Opportunity cost | |
| Maintains control | May not cover large investments | |
| Sale of Assets | Immediate cash | Loss of future use |
| No debt or interest | One-time solution | |
| Improves efficiency | Potential undervaluation |
Potential undervaluation
When an asset is valued at a lower price than it should be. It is generally a loss making deal for the seller and profit making deal for the buyer.
