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2.1.1 Internal Finance

Types of internal finance:

  • Owner’s capital/personal savings – The personal savings of the business’s owner.
  • Retained profit – The profit that the business has made so far through trade.
  • Sale of assets – The sale of business assets such as machinery.

 

A) Owner’s capital

Benefits

  • No debt – By using owner’s capital as a source of finance it means that the business does not have to take out any loans. As a result of this they will not have any debt that will need to be paid off.
  • Quick – No approval is needed in order to use owner’s capital to invest in the business. This allows the business to re-invest the capital quickly and therefore may be useful when operating in a dynamic market.

Drawbacks

  • Limited funds available – The Capital that the owner has available to invest in the business is likely to be limited. As a result of this, owner’s capital would be an unsuitable source of finance if the business were looking at sources of finance for activities such as expansion which would require a much larger amount of capital
  • Risk of losing savings – If the business fails and goes bankrupt then the owner will lose any capital that they have put into the business. As a result of this, there is a risk when using owner’s capital as a source of finance that the owner will lose the savings that they have invested into the business.

 

B) Retained profit

Benefits

  • No debt – By using this source of finance it means that the business may not have to use loan capital. As a result of this, no interest has to be paid. This will reduce the long term liabilities of the business which will result in a lower gearing ratio.
  • Flexible – The amount of retained profit used to invest in the business is chosen by the owner. They will also decide where to invest the profits which can be in contrast to some of the other types of finance. Therefore retained profit is a flexible source of finance.
  • Retain control – Owners are able to raise finance without having to dilute some of the power that they have in the business. This is due to the fact that they will not have to sell any shares. This will also mean that the profit spent on dividends will also be low. This is a benefit as it reduces the chances that another business will be able to successfully takeover the business through buying more than 50% of the business’s shares.

 

Drawbacks

  • Reduce dividends for shareholders – By using retained profits to reinvest in the business it means that there will be less profit left to give to shareholders. As a result of this, the dividends that they receive will be lower. This may result in shareholders becoming unhappy. This is especially the case if the return on capital employed is low meaning that the benefit of investment is limited (ROCE % = Operating profit/Capital employed X 100).
  • Businesses with higher profit can afford debt – This is due to the fact that the business is likely to have a relatively low gearing ratio. This is due to the fact that high profits will mean that the business has a high amount of capital employed (capital employed = Non-current assets +current assets – current liabilities). Therefore, they can afford to increase their long term liabilities through loaning money as their gearing ratio will remain relatively low regardless meaning they will be able to pay for their loan repayments.
  • Slow process – It can take a long time for a business to gain enough profit that is substantial enough in order to reinvest in the business. This is especially the case for new businesses due to the fact that most businesses aim to survive in their first year. Therefore some smaller businesses will not have any profit at all in order to invest. Furthermore, by the time that the business has made enough profit to reinvest, competitors may have done so a long time ago. Therefore the business risks losing market share if they wait to make a substantial amount of profit. This is especially the case in dynamic markets.
  • Limited profits – Most businesses are unlikely to have the retained profit required in order to fund big investments in their business e.g. expansion. Therefore, the source of finance is unlikely to be suitable when making big investments in the business. This is especially the case for smaller businesses that make small amounts of profit.

 

C) Sale of assets

Benefits

  • Assets depreciate in value – By selling assets as a source of finance it means that the business will be able to get the money from the assets before they depreciates in price.
  • Poor quality assets can be sold to buy better quality assets – Selling some of the business’s assets could be used in order in order to buy other assets that are of better quality e.g. newer machinery. This means that they are able to do the same job but more efficiently. This is likely to save the business lots of money in the long term.

Drawbacks

  • Lose benefit from the asset – By selling the asset it means that the business can no longer benefit from the function of the asset. For example, if a business were to sell some machinery then it means that the machinery could no longer be used in order to produce goods. Therefore, by selling assets it may result in a decrease in productivity and therefore output if it is not replaced.
  • Asset no longer on the balance sheet – By selling business’s assets it will result in a reduction in the value of the non-current assets that a business has such as machinery. As a result of this, the value of a business’s total assets will be reduced and therefore the overall valuation of the business will be reduced also.

Sole Trader – A sole trader is likely to use owner’s capital as an internal source of financing. This is due to the fact that they are unlikely to be able to use retained profits as they are unlikely to have a substantial amount. Furthermore, they are unlikely to have very many assets and therefore won’t be able to raise sufficient funds. This is especially the case if the business has just started up.

Partnership – A partnership may be able to use retained profit depending on how successful the business is. Furthermore, they could also use sale of assets and owners capital.

LTD and PLC – Both types of business are most likely to use retained profits as they are likely to be much more profitable than sole traders and partnerships. Therefore it would be unnecessary for them to use owner’s capital. However, they could use sale of assets as a means of raising finance. However, if the business is run efficiently then they are unlikely to have a surplus of assets available to them that they can sell.

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