Notes

internal sources of finance:

Sources of finance are the various ways that a business gets its money in order to run the business, such as from personal funds, share capital or bank loans. The sources of finance for a business can be classified as either internal sources or external sources.

Internal sources of finance are those that come from within the organization, from its own resources and assets, without the help of a third party. Internal sources of finance do not have to be repaid to anyone, as they belong to the owner or organization. There are three main sources of internal finance:

personal funds (for sole traders)
retained profit, and
the sale of assets.
Personal funds (for sole traders) (A02)

Personal funds are mainly from savings

Sole traders and partners, as types of business entities, usually rely on personal funds from their own savings to finance their start-up businesses.

The advantages of using personal funds as an internal source of finance include the following points:

Personal funds do not need to be repaid.
There are no interest charges incurred either, unlike with external finance.
By investing their personal funds, sole traders and partners have a better chance of being able to borrow money if they need to, as it shows greater commitment to the business venture.
Whilst internal sources of finance are the cheaper of the two options, external sources of finance usually generate much more funds for a business.
However, the disadvantages as an internal source of finance include the following:

As sole traders represent relatively high risk, they are less likely to be able to secure external sources of finance, so need to rely on their personal funds.
Personal funds are rarely sufficient for most small businesses.
Many entrepreneurs risk their entire life savings in a business venture. In particular, sole traders and partners risk losing all their personal funds if the business venture fails.
Retained profit (A02)

Retained profits are a vital source of finance

Profit exists when a firm’s total revenue exceeds its total costs. Profit belongs to the owners of the business, but can be distributed as a financial reward for the owners and/or retained within the business as an important source of internal finance. Retained profit is an internal source of finance that comes from having a financial surplus. These funds are reinvested in the business, rather than being distributed to the owners (shareholders). Hence, retained profit is also known as ploughed-back profit.

In essence, retained profits are rather like a firm’s savings which have been built up over time. For established businesses, it is the primary source of investment income. Retained profit is recorded and shown in the balance sheet as part of a firm’s equity.

Advantages of using retained profit as an internal source of finance include the following:

As an internal source of finance, retained profit does not incur any interest charges.
As the money belongs to the business, it is considered as a permanent source of finance, because it doesn’t have to be repaid. If a business project fails, the use of retained profit does not necessarily pull the organization into debt.
The business also has great flexibility in the use of retained profit - the business can use this for any purpose within the business. By contrast, bank loans are approved for specific uses only.
However, the disadvantages as an internal source of finance include the following points:

Start-up business don’t have any retained profit, so this is not a possible source of finance for creating a new business.
Retained profit is rarely enough as a sole source of finance for most businesses in their pursuit of growth and evolution.
Using the funds as retained profits for use to grow the business means there is less dividends paid out to shareholders and owners of the business.
Sale of assets (A02)

Another source of internal finance is the sale of assets. An asset is anything that a business owns and has a marketable value, such as buildings, vehicles, computers, equipment and intellectual property. Fixed assets are items a business owns and:

uses for a period of more than 12 months
can be used repeatedly
generates income for the organization.
Factories are an example of fixed assets of a business

When a business is in need of cash, it can sell off some of its fixed assets. Many businesses dispose of their old or obsolete assets, rather like an individual who might choose to replace their personal computer after a few years or have their family car upgraded.

The advantages of using the sale of assets as an internal source of finance include:

A large sum of money can be raised. For example, selling a fleet of old motor vehicles or a redundant (unused) office building can raise much needed finance for a business.
The sale of excess resources, redundant assets or obsolete (outdated) belongings is a sensible way for a business to raise finance. The alternative is that these resources would tie up much needed working capital for the organization.
Again, there are no costs of borrowing involved or interest repayments to make.

However, there are disadvantages of the sale of assets as an internal source of finance too, such as:

The sale of certain fixed assets can hinder a firm’s productive capacity. For example, a struggling business that sells some of its computer equipment or machinery, which may actually be needed for production.
It can be very time consuming to find a suitable buyer for second-hand assets, especially if these are obsolete. Even if a buyer can be found, the purchase price is likely to be very low as the business is in a weaker bargaining position, especially if the business is desperate for cash.
The option of asset sales is only available to established businesses; new businesses are unlikely to be in such a position.