Internal sources of finance

• Retained profit — profit kept in the business rather than paid as dividends. No interest, no loss of control, available immediately. But it is limited to what has been earned, and shareholders may object to a lower dividend. It is not free: it has an opportunity cost.
• Sale of assets — sell surplus machinery, land or a division. Turns idle assets into cash; a one-off, and you may need the asset later. Sale and leaseback raises cash but commits the firm to rent forever.
• Working capital management — cut inventory, chase debtors, delay payables. Frees cash without any borrowing.

External sources of finance

Short term (for working capital and cash flow):

• Overdraft — flexible, interest only on what is used; expensive and repayable on demand.
• Trade credit — pay suppliers in 30–90 days; effectively free, but abuse it and suppliers withdraw terms.
• Debt factoring — sell your invoices for immediate cash (typically 80–90% of face value); fast but costly.

Long term (for capital investment):

• Bank loan — a fixed sum repaid with interest over years. Predictable, no loss of control, but interest must be paid whatever profit is, and security is usually required.
• Share capital — sell ordinary shares. Never has to be repaid, no interest; but it dilutes ownership and control and dividends are expected. Only a plc can sell shares publicly.
• Venture capital — equity plus expertise for high-growth firms; expensive in ownership terms.
• Leasing — use the asset without buying it; no large upfront outlay, but more expensive over the asset's life.
• Crowdfunding and grants.

Choosing: match the source to the use — long-term assets with long-term finance, short-term cash gaps with short-term finance. Also weigh cost, control, risk (gearing) and the legal structure of the business.

Quick check

Sort the sources of finance

Tap a source, then tap the correct category.

The income statement

The gross profit margin here is (480 ÷ 1,200) × 100 = 40%; the operating profit margin is (170 ÷ 1,200) × 100 = 14.2%. A widening gap between the two means overheads are rising faster than sales.

Your turn — gross profit

The statement of financial position

The statement of financial position (balance sheet) is a snapshot of what the business owns and owes on one day.

Your turn — capital employed

ROCE — the primary efficiency ratio

Return on capital employed shows how much operating profit is generated for every £100 of long-term capital invested. It is the single best test of how efficiently a business uses its finance, and it is comparable across firms of different sizes.

Your turn — ROCE

Gearing — how the business is financed

Highly geared (usually above 50%) means the firm relies heavily on long-term debt.

• + Debt is cheaper than equity and interest is tax-deductible; owners keep control; profits are spread over fewer shares, so returns to shareholders are amplified when trading is good.
• − Interest must be paid whatever happens. In a downturn, or when interest rates rise, a highly geared firm can be pushed into insolvency. Lenders will demand higher rates.

Context is everything: a utility with stable, predictable cash flows can safely carry high gearing. A fashion retailer with volatile sales cannot.

Your turn — gearing

Quick check

Quick check

Match the ratio to its formula

Tap a card on the left, then its partner on the right.

Using ratios — and their limits

A ratio on its own means nothing. Ratios are only useful when compared:

• Over time (trend analysis) — is ROCE rising or falling?
• Against competitors in the same industry — a 4% margin is disastrous for software and normal for a supermarket.
• Against the firm's own targets and the cost of its capital.

Limitations: published accounts are historic; they ignore qualitative factors (brand, staff morale, innovation pipeline); different accounting policies distort comparison; and window dressing can flatter the figures on the one day the snapshot is taken.

Your turn — operating profit margin

Quick check