Internal and external sources of finance, short-term and long-term finance, and the factors a business considers when choosing the most appropriate source.

What this dot point is asking

CCEA wants you to identify internal and external sources of finance, distinguish short-term from long-term finance, and evaluate the factors that determine the most appropriate source for a given need.

Internal sources of finance

Internal finance is generated by the business itself, with no borrowing.

• Retained profit - profit kept in the business rather than paid out. It is cheap (no interest) and flexible, but only available to established, profitable firms, and using it means less for owners.
• Sale of assets - selling unused equipment or premises to raise cash, though the firm loses the use of the asset.
• Reducing stock or tighter working capital - releasing cash tied up in inventory, though too little stock risks shortages.

External sources of finance

External finance is raised from outside the business.

• Bank loan - a lump sum repaid over a fixed period with interest; predictable but adds cost and may need security.
• Overdraft - permission to spend more than is in the bank account up to a limit; flexible for short-term gaps but interest rates are high.
• Share capital - money raised by selling shares (companies only); no repayment or interest, but dilutes ownership and shares profit through dividends.
• Trade credit - buying supplies now and paying later (commonly 30 to 90 days); interest-free short-term finance, but delaying payment can harm supplier relations.
• Mortgage - a long-term loan secured on property.
• Leasing and hire purchase - using an asset while spreading payments; avoids a large upfront cost, though it can cost more over time.
• Government grants - funds that need not be repaid, often tied to conditions such as location or job creation.

Short-term and long-term finance

Factors influencing the choice of source

The most appropriate source depends on:

• Purpose - day-to-day need or long-term asset (match the term).
• Amount required - small sums may come from savings; large sums need loans or shares.
• Cost - interest rates and fees versus the dilution of issuing shares.
• Legal structure - only companies can issue shares.
• Control - borrowing keeps ownership; issuing shares may dilute control.
• Risk and gearing - too much borrowing raises interest costs and the risk of insolvency.

Try this

Q1. State two internal sources of finance. [2 marks]

• Cue. Retained profit, sale of assets, reducing stock or tighter working capital (any two).

Q2. Explain why trade credit is a useful short-term source of finance. [3 marks]

• Cue. It lets the firm receive supplies now and pay later, easing cash flow at no interest cost, though it must not damage supplier relations.

Q3. Analyse why a business should match the source of finance to the purpose. [6 marks]

• Cue. Long-term assets should be funded by long-term sources and short-term needs by short-term sources, so repayments fit the cash the asset or activity generates and avoid high overdraft costs.