Money the business already has

• Owner's capital (personal savings): no interest, no loss of control, and it signals commitment to lenders. But it is limited by the owner's wealth and puts their personal money at risk.
• Retained profit: profit kept in the business rather than paid out as dividends. Free of interest and available immediately — but it is not free of opportunity cost (shareholders forgo a dividend) and start-ups have none.
• Sale of assets: selling machinery, property or a division releases cash from the balance sheet. It suits firms with surplus assets; sale and leaseback raises cash while keeping the use of the asset, at the price of an ongoing rental cost.

Key advantage of internal finance: no interest, no repayment schedule and no dilution of ownership. Key limitation: the amount available is capped by the firm's own resources, so rapid growth almost always requires external finance.

Sources and methods of external finance

Sources (who the money comes from): family and friends, banks, peer-to-peer funding, business angels (wealthy individuals who invest in early-stage firms and bring expertise), crowdfunding (many small investors via a platform) and other businesses.

Methods (the form the money takes):

• Loans — a fixed sum repaid with interest over an agreed term. Predictable and no loss of ownership, but interest must be paid whatever the profit is, and security is usually required.
• Share capital — selling equity. No repayment obligation, but ownership and future profits are diluted.
• Venture capital — large equity investment in high-growth, high-risk firms, usually with a board seat and an exit plan.
• Overdraft — a facility to go into debit. Flexible and ideal for short-term working-capital gaps, but high interest and repayable on demand.
• Leasing — renting an asset instead of buying it. No large upfront outlay and maintenance is often included, but the total cost exceeds outright purchase and the firm never owns the asset.
• Trade credit — buying now and paying the supplier in, say, 60 days. Interest-free short-term finance, but late payment damages supplier relationships.
• Grants — usually from government. No repayment, but conditions are attached and competition is intense.

Where does the money come from?

Tap a source of finance, then tap the category it belongs to.

Matching finance to need

Your turn — the cost of a loan

Liability and the finance available

Unlimited liability (sole trader, ordinary partnership): the owner and the business are legally the same. Personal assets can be taken to settle business debts.

Limited liability (Ltd, plc): the company is a separate legal entity, so shareholders can lose only what they invested.

Why this determines finance:

• An unlimited-liability business cannot sell shares. It is restricted to owner's capital, retained profit, loans, overdrafts, trade credit and grants — and lenders often demand a personal guarantee secured on the owner's home.
• A limited company can issue share capital, attract venture capital and business angels, and (if a plc) float on the stock market. It also has audited published accounts, which makes lenders more willing to lend.

Evaluation: incorporating widens access to finance and protects personal assets, but brings disclosure, compliance costs and — where equity is sold — dilution of control.

Liability and lending

The business plan and the cash-flow forecast

A business plan sets out the idea, the market research, the marketing plan, the operations plan, the management team and the financial forecasts. Its relevance in obtaining finance is that it turns an idea into evidence: it shows a lender or investor that demand has been researched, that the numbers work and that the entrepreneur understands the risks. It also imposes discipline and gives a benchmark against which performance can be judged.

A cash-flow forecast predicts money in and money out, month by month.

Cash is not profit. A profitable firm can run out of cash if customers pay slowly, if it holds too much stock, or if it grows too fast (overtrading). Cash-flow forecasting is how a firm sees a crisis coming and arranges an overdraft before it needs one.

Your turn — closing balance

Your turn — changing a variable

Acting on the forecast

Match the finance to the need

Tap a business need on the left, then the most suitable method of finance on the right.

The limitations of a cash-flow forecast

Cash-flow forecasts are essential, but at A-level you must challenge them:

• They are built on estimates — especially sales, which are the hardest figure to predict for a new business with no trading history.
• They assume customers pay on time. In practice late payment is the single most common cause of a forecast going wrong.
• They cannot anticipate external shocks — a recession, a supplier failure, an energy price spike.
• A forecast is only as good as the assumptions behind it; an entrepreneur seeking a loan has an incentive to be optimistic.

Improve the judgement: forecasts are more useful when they are updated monthly and stress-tested with a sensitivity analysis — what happens to the closing balance if sales are 20% below forecast or customers take 90 days rather than 30?

Evaluating leasing

Equity or debt?

The big ideas to know

You have covered internal and external finance, liability and cash-flow planning for Theme 2.1. Press Finish to see your score.