Where do businesses get the money they need and how do they choose?
Internal and external sources of finance, short-term and long-term finance, the distinction between debt and equity, and how the choice of source depends on cost, risk, purpose and the type of business.
A focused answer to AQA A-Level Business 3.5, covering internal and external sources of finance, short-term and long-term finance, the distinction between debt and equity, and how the choice of source depends on cost, risk, purpose and the type of business.
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What this dot point is asking
AQA wants you to distinguish internal and external sources of finance, short-term and long-term finance, and debt and equity, and to explain how a firm chooses the right source. Exam questions are almost always applied: a named firm with a specific need, where you must recommend and justify a source given its cost, risk, purpose and the type of business.
Internal and external sources
Internal finance is attractive because it carries no interest and no loss of control, but it is limited by how much profit or spare asset the firm actually has, and retained profit has an opportunity cost (it could have been returned to owners or invested elsewhere). External finance can raise far larger sums but brings interest, fees or dilution.
Short-term and long-term
Debt versus equity
Debt finance (loans and bonds) must be repaid with interest and increases gearing and financial risk, but the owners keep control and interest is tax-deductible. Equity finance (issuing shares) needs no repayment and carries no interest, easing cash flow, but it dilutes ownership and the existing owners share future profit and control with new shareholders. Only a company can issue shares; a sole trader cannot, which is one reason the choice depends on the legal form of the business.
Choosing a source
The choice depends on the cost (interest, fees, dilution of future profit), the level of risk the firm can bear (more debt means more gearing and a heavier fixed burden), the purpose (short-term need versus long-term investment, so finance is matched to it), the type and size of business (a sole trader cannot issue shares; an established plc can tap the stock market), and the state of the economy and lending market (high interest rates make debt costly; a buoyant market makes a share issue easier).
Exam-style practice questions
Practice questions written in the style of AQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
AQA 20209 marksA growing private limited company needs million to build a new factory. Analyse the case for funding this with a long-term bank loan rather than by issuing new shares. (9 marks)Show worked answer →
Build a two-sided analysis, then a supported judgement.
For a loan: the existing owners keep full control and the whole of any future profit, since no new shares dilute ownership; the interest is a known, fixed cost that can be planned for; and interest is tax-deductible, lowering the effective cost. A loan also matches a long-term asset (a factory) with long-term finance.
Against a loan (and for shares): the loan must be repaid with interest regardless of how the firm trades, which raises gearing and financial risk; in a downturn the fixed interest burden can threaten survival. A share issue needs no repayment and carries no interest, easing cash flow, but it dilutes ownership and control and as a private limited company the firm can only sell shares privately.
Judgement: if the firm's cash flows are stable enough to service the interest and the owners value keeping control, a loan is the stronger choice for a long-term, income-generating asset like a factory. Markers reward developed points on both sides (cost, control, risk, repayment) and a justified recommendation linked to this firm's circumstances.
AQA 20184 marksExplain why matching the term of finance to its purpose reduces a firm's risk. (4 marks)Show worked answer →
Matching means funding short-term needs with short-term finance and long-term needs with long-term finance.
If a firm funds a long-term asset such as machinery with a short-term overdraft, the bank can demand repayment before the asset has generated enough cash to repay it, forcing a cash crisis or a fire-sale of the asset. Conversely, funding a temporary stock build with a 10-year loan means paying interest long after the need has passed, wasting money. Matching ensures the finance is available for as long as the need lasts and no longer, so the firm avoids both a sudden repayment squeeze and unnecessary interest. Markers reward the principle plus a worked example of the risk of mismatching.
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Sources & how we know this
- AQA A-level Business (7132) specification — AQA (2015)