1The idea in one paragraph

A source of finance is where a business gets money from. It can come from inside the business (internal: the owner's own money, profit it has kept, things it can sell) or from outside (external: shareholders, banks, suppliers, crowds of small backers, wealthy individuals, specialist lenders). Each source has a cost (interest, fees, a share of future profit, a discount given up), a term (how long before it must be repaid, if ever) and a price in control (whether someone else now owns part of the business). There is no best source. There is only the best source for this business, for this purpose, now, and the rule that settles most cases is simple: match the life of the finance to the life of what it pays for.

2Two ways to sort the sources

Internal sources come from within the business itself. External sources come from people or organisations outside it. Figure 1 places all eleven the guide lists.

The second way to sort them is by term, meaning how long the money is available before it has to be repaid.

• Short-term finance is repaid, or is meant to be repaid, within a year. Overdrafts and trade credit are the two the guide names. They pay for revenue expenditure and for gaps in cash flow.
• Long-term finance is available for more than a year, often many years, and some of it (share capital, retained profit) is never repaid at all. It pays for capital expenditure. Some textbooks split off medium-term finance (roughly one to five years: most bank loans and leases), but the guide's question is simply whether the source is short- or long-term for the situation.

Keep one invented business in mind through the page. Tallow & Wick makes hand-poured candles. Rhiannon Price started it as a sole trader at her kitchen table, and over five years it has grown into a private limited company with a workshop, a van and three employees. At almost every stage it needed money, and it used almost every source.

3Internal sources

Personal funds are the owner's own savings, put into the business. For a sole trader they are usually the first and biggest source, because a new business with no track record finds it hard to borrow. Rhiannon started with €12,000 of her savings.

• For: no interest, no repayment date, nobody else to answer to, and it shows lenders the owner is committed, which makes other finance easier to get.
• Against: limited by how much the owner has, and the owner risks their own money. A sole trader has unlimited liability, so if the business fails the owner can lose far more than the savings put in.

Retained profit is the profit a business keeps after paying tax and any dividends to its owners, and reinvests in itself. It is the last line of the statement of profit or loss in 3.4. In one year Tallow & Wick Ltd made a profit for the period of €46,000 and paid dividends of €16,000, so it retained €30,000.

• For: no interest, no repayment, no loss of control, and no fees to raise it. It is the cheapest finance a profitable business has, and the most common source of long-term finance for established firms.
• Against: only exists if the business made a profit, so it is closed to start-ups and to firms in trouble. It may be too small for a large project. And it has an opportunity cost: every euro kept is a euro not paid to shareholders, who may prefer dividends now.

Sale of assets means selling things the business owns but no longer needs: surplus land, an old van, machinery replaced by newer models. Tallow & Wick sold its first, smaller van for €6,500 when it bought a bigger one. A variation is sale and leaseback: a business sells an asset it still needs, often its building, to an investor and then rents it back, turning a fixed asset into cash while keeping the use of it.

• For: no interest, no loss of control, and it turns idle assets into useful cash.
• Against: only works if there are spare assets, can take time (a building may take months to sell), is a one-off, and a quick sale may fetch less than the asset is worth. With sale and leaseback the business now pays rent for something it used to own.

4External sources that are long-term

Share capital is money raised by selling shares, units of ownership, in a limited company. Only companies can raise it, which is one reason sole traders become companies as they grow: the guide's point that a change in business structure changes the financial resources available.

A private limited company sells shares privately, to people the owners choose: family, friends, employees, an investor. A public limited company can sell shares to the general public through a stock exchange; its first sale to the public is an initial public offering (IPO).

When Tallow & Wick became a company, Rhiannon held all 10,000 shares. To pay for a second workshop room she sold 2,500 new shares at €20 each to members of her family.

• For: permanent finance that never has to be repaid, and no interest. Dividends are paid only if the directors decide the company can afford them. Shareholders have limited liability, which makes them willing to invest.
• Against: every new share dilutes the existing owners' control and their share of future profit, as Figure 2 shows below. Shareholders expect a return, and a public company whose shares are cheap can face a takeover. Going public is expensive and slow, and far more information must be published.

Loan capital is money borrowed from a bank or other lender for a fixed period, repaid in instalments with interest. A loan secured on property, repaid over many years, is a mortgage. Lenders usually want collateral, an asset they can take and sell if the loan is not repaid.

Tallow & Wick borrowed €60,000 over five years for a delivery van and packing equipment, repaying €1,188 a month.

• For: the owners keep full control; repayments are known in advance, which makes planning easier; the lender gets interest and nothing more, however well the business does.
• Against: interest must be paid whether the business profits or not; missing repayments can cost the business the asset used as collateral; variable interest rates can rise; and the more a business borrows, the riskier it becomes to its lenders and owners (HL students measure this as gearing in 3.6).

Leasing is renting an asset, a vehicle, machinery, IT equipment, for regular payments over an agreed period, instead of buying it. The lessor (a leasing company) owns it; the lessee (the business) uses it. Tallow & Wick needed a second van. It could buy one for €30,000 or lease one for €640 a month for four years.

• For: no large outlay, so cash is kept for other uses; payments are regular and easy to budget; maintenance is often included; the business can move to newer equipment when the lease ends, which matters for fast-changing technology.
• Against: over the full term leasing usually costs more than buying, and at the end the business owns nothing (Tallow & Wick pays €720 more and hands the van back). The business is tied into payments for the full term even if it no longer needs the asset.

Business angels are wealthy individuals who invest their own money in small, young businesses with growth potential, usually in exchange for shares. Many are experienced entrepreneurs themselves. An angel offered Tallow & Wick €80,000 for a 20% stake.

• For: money for businesses too young or risky for a bank, with no repayments or interest; and the angel usually brings expertise and contacts, which can be worth more than the money.
• Against: the owners give up part of the business and some control, often a seat on the board; angels expect a high return and may push for fast growth or a sale of the business within a few years; and good angels are hard to find, since they choose a small share of the businesses that approach them.

Figure 2 shows how two rounds of share selling have shrunk Rhiannon's slice from all of it to under two-thirds, even though the business has grown.

Crowdfunding is raising money from a large number of people, each giving a small amount, usually through an online platform. Backers may get a product or perk (reward-based), shares (equity-based), nothing at all (donation-based, common for social enterprises), or interest on a loan (lending-based). Many platforms are all-or-nothing: miss the target and the business gets nothing. Tallow & Wick ran a reward campaign for a new range of refillable candles, with a target of €45,000. It raised €52,000 from 1,300 backers. Figure 3 shows what was left.

• For: money from people who are also the first customers, so a successful campaign tests demand and is marketing in its own right; open to businesses that banks turn away; no loss of control in reward and donation types.
• Against: a campaign takes weeks of work and may fail in public; fees and rewards swallow much of the money, as Figure 3 shows; a published idea can be copied before it is made; and hundreds of backers expect the product on time, so a delay becomes a public relations problem.

5External sources that are short-term

Overdrafts let a business take more out of its bank account than it holds, up to an agreed limit. Interest is charged only on the amount overdrawn and only for the days it is overdrawn, usually at a higher rate than a loan. Tallow & Wick has a €15,000 limit and uses it every autumn, when it buys wax and jars for the Christmas season weeks before the shops pay. One year it was €8,000 overdrawn for 20 days at 18% a year.

• For: flexible, quick to arrange once agreed, and cheap when used briefly, because the business pays only for what it uses when it uses it. It is the right tool for short, uneven gaps in cash flow.
• Against: the interest rate is high, so an overdraft used all year round becomes expensive; and the bank can reduce or cancel it, and demand repayment, at short notice, usually at exactly the moment the business is struggling. That is why it must never pay for a long-lived asset (Figure 4, in section 7).

Trade credit is when a supplier delivers goods now and allows payment later, commonly 30, 60 or 90 days. The amount owed appears on the statement of financial position as trade creditors. Tallow & Wick's wax supplier gives 30 days' credit, which means the candles can often be made and sold before the wax is paid for.

• For: no interest; it is in effect a short loan from the supplier, and it is automatic once a relationship is established.
• Against: new businesses may not be offered it; paying late damages the relationship and can mean losing credit altogether; and it can have a hidden cost. Many suppliers offer a discount for paying early. The wax supplier offers 2% off a €20,000 order if it is paid within 10 days instead of 30.

A business with spare cash should usually take the discount; a business short of cash may reasonably decide that 20 more days of credit is worth €400.

6Microfinance providers

Microfinance providers offer very small loans (microcredit), and often savings accounts and insurance, to people on low incomes who have no access to ordinary banks, usually because they have no collateral and no credit history. The borrowers are typically sole traders and very small businesses in low-income countries, and many providers lend mainly to women. The best-known early example is Grameen Bank in Bangladesh, which grew from Muhammad Yunus's lending experiments in the 1970s; Yunus and the bank shared the 2006 Nobel Peace Prize.

Many lend to groups of borrowers who cannot borrow again until the whole group has repaid, which takes the place of collateral. Many providers are themselves social enterprises, which links this source to HL Paper 3.

Picture (invented) Esi, who sells dried fruit from a market stall. A bank will not lend her €150 for a solar dryer, because the loan is too small to be worth its paperwork and she has nothing to secure it against. A microfinance provider lends it, repaid weekly over six months. The dryer halves her waste, and the extra sales repay the loan.

• For: reaches people no other lender will; small, frequent repayments suit small, frequent earnings; it can lift households out of poverty and build a local economy, which is why it matters to Paper 3.
• Against: interest rates are usually higher than bank rates, because the cost of making and collecting thousands of tiny loans is high; the sums are too small for anything but a very small business; and where lending grows too fast, some borrowers take several loans to repay each other and fall into debt. Whether a provider charges fair rates is an ethical question, and a good answer asks it.

7Choosing: short-term or long-term, and which one

The guide asks you to judge whether a source is appropriate for a given situation. That is an AO3 skill: there is no single right answer, but there are well-argued and badly argued ones. The first test is always matching.

Match the finance to the use. Long-lived assets (capital expenditure) should be paid for with long-term finance. Short-term needs (revenue expenditure, gaps in cash flow) should be met with short-term finance.

Figure 4 shows why. A van earns its cost back over five years, so a five-year loan is repaid out of what the van earns. An overdraft used for the same van can be called in next month, and the business would have to find €30,000 it has not yet earned. Using long-term finance for a short-term need is wasteful the other way: a five-year loan for Christmas stock means paying interest for years on money needed for weeks.

Matching narrows the choice. Figure 5 finishes it: six questions whose answers pick one source for this business now.

Here are the six questions applied to real choices Tallow & Wick faced.

One more factor sits outside the business: the external environment. When interest rates are high, loans cost more and selling shares looks relatively better; when the economy is uncertain, banks lend less and angels invest less. A strong answer uses the case's numbers, weighs cost against control against risk, chooses, and says what would change the choice.