Internal sources of finance: retained profit, sale of assets, working capital

What you'll learn

This revision guide covers the three main internal sources of finance available to businesses: retained profit, sale of assets, and working capital. You'll understand how businesses use their own resources to fund operations and expansion without borrowing from external sources. This topic appears regularly in Paper 1 and Paper 2 questions, particularly when evaluating finance options for different business situations.

Key terms and definitions

Internal sources of finance — money raised from within the business itself, rather than from external providers such as banks or investors

Retained profit — profit after tax that is kept in the business rather than distributed to shareholders as dividends

Sale of assets — raising finance by selling items owned by the business, such as machinery, vehicles, property or inventory

Working capital — the day-to-day finance available to a business, calculated as current assets minus current liabilities

Fixed assets — long-term resources owned by a business such as buildings, machinery and vehicles that are used repeatedly over several years

Current assets — short-term assets that can be quickly converted into cash, including inventory, receivables and cash itself

Dividends — payments made to shareholders from the company's profits as a reward for their investment

Capital expenditure — spending on fixed assets that will be used over a long period, such as new equipment or premises

Core concepts

Retained profit as a source of finance

Retained profit represents the accumulated earnings that a business has kept rather than distributing to shareholders. Each year, businesses decide how much profit to retain and how much to pay out as dividends.

How retained profit works:

• At year-end, businesses calculate profit after tax
• Directors propose a dividend payment to shareholders
• The remaining profit is added to retained profit reserves
• This money stays in the business permanently unless withdrawn
• The accumulated total appears in the balance sheet under equity

Advantages of using retained profit:

• No interest charges or repayment schedules unlike loans
• No dilution of ownership as no new shares are issued
• Quick access without lengthy application processes
• Flexible — can be used for any business purpose
• Demonstrates financial strength to potential investors and lenders
• No arrangement fees or legal costs

Disadvantages of using retained profit:

• Only available to established, profitable businesses
• Start-ups and new businesses have no retained profit
• May be insufficient for large investment projects
• Reduces dividends, potentially disappointing shareholders
• Opportunity cost — the money could have been invested elsewhere for higher returns
• Takes time to accumulate substantial amounts

When retained profit is most suitable:

Retained profit works best for medium-sized expansion projects in profitable, established businesses. A manufacturing company might use £200,000 of retained profit to purchase new machinery, or a retailer might finance a store refurbishment without external borrowing.

Sale of assets

Businesses can generate finance by selling items they own. This converts fixed or current assets into cash that can be used elsewhere in the business.

Types of assets commonly sold:

Fixed assets:

• Unused or old machinery and equipment
• Vehicles no longer needed
• Surplus buildings or land
• Outdated technology systems

Current assets:

• Excess inventory through clearance sales
• Raw materials no longer required

Advantages of selling assets:

• Provides immediate cash injection
• No interest costs or repayments
• Removes maintenance costs for unwanted items
• Can dispose of obsolete or inefficient equipment
• No impact on ownership structure
• Improves efficiency by focusing on productive assets

Disadvantages of selling assets:

• Only possible if business owns saleable assets
• May receive less than the asset's book value
• Reduces productive capacity if selling useful equipment
• One-time source — asset can only be sold once
• May signal financial difficulties to stakeholders
• Takes time to find buyers and complete sales
• Tax implications on capital gains

Sale and leaseback arrangements:

A specialized form of asset sale where a business sells a fixed asset (typically property) to a finance company, then immediately leases it back. This provides a large cash sum while maintaining use of the asset.

Example: A hotel chain sells its building for £2 million to a property investment company, then leases it back for £150,000 annually. The hotel continues operating but now has £2 million cash for expansion.

Benefits: Large cash injection, maintain use of asset, convert fixed cost to operational expense

Drawbacks: Long-term lease costs may exceed original ownership costs, no longer own appreciating asset, ongoing lease obligations

Working capital as a source of finance

Working capital represents the cash available for daily operations. Businesses can release working capital by managing their current assets and liabilities more effectively.

The working capital cycle:

1. Business purchases raw materials (cash out)
2. Materials are converted into finished goods (inventory)
3. Goods are sold to customers (often on credit)
4. Cash is collected from receivables
5. Cycle repeats

Methods to release working capital:

Reducing inventory levels:

• Implement just-in-time (JIT) stock management
• Clear slow-moving or obsolete stock through sales
• Negotiate more frequent, smaller deliveries from suppliers
• Improve demand forecasting to avoid overstocking

Collecting receivables faster:

• Reduce credit periods offered to customers (e.g., from 60 to 30 days)
• Offer early payment discounts (e.g., 2% discount for payment within 10 days)
• Implement stricter credit control procedures
• Chase overdue payments more actively
• Use debt factoring services

Extending payables periods:

• Negotiate longer credit terms with suppliers
• Delay payments while maintaining supplier relationships
• Take full advantage of credit periods offered

Advantages of using working capital:

• Already belongs to the business — no external approval needed
• No interest charges
• Quick to implement efficiency improvements
• Improves overall business efficiency
• No impact on ownership or control

Disadvantages of using working capital:

• Limited amounts available
• Reducing inventory may cause stock-outs and lost sales
• Shorter customer credit may reduce competitiveness
• Delaying supplier payments may damage relationships
• Can only be released once — not a recurring source
• May indicate cash flow problems to suppliers

Calculating working capital:

Working Capital = Current Assets - Current Liabilities

Example calculation:

• Current assets: £75,000 (inventory £30,000 + receivables £35,000 + cash £10,000)
• Current liabilities: £45,000 (payables £40,000 + overdraft £5,000)
• Working capital: £75,000 - £45,000 = £30,000

Positive working capital indicates the business can meet short-term obligations. By reducing inventory to £20,000 and receivables to £25,000 through better management, the business could release £20,000 cash while maintaining £20,000 working capital.

Comparing internal sources of finance

Key comparison factors:

Selection criteria:

The appropriate internal source depends on:

• Amount needed — large amounts require sale of major assets
• Urgency — retained profit is fastest if available
• Business stage — start-ups cannot use retained profit
• Purpose — working capital suits short-term needs
• Asset availability — must own disposable assets
• Profitability — retained profit requires sustained profits

Worked examples

Example 1: Identifying appropriate internal finance

Question: TechStart is a two-year-old software company that has made small profits in both years. It needs £50,000 to develop a new application. The company has £15,000 retained profit, owns equipment worth £30,000, and has working capital of £25,000.

Identify and justify which internal source(s) of finance would be most suitable for TechStart. [6 marks]

Model answer:

TechStart should use a combination of retained profit and working capital. [1 mark for identification]

The £15,000 retained profit should be used first because it is immediately available and has no disadvantages for a growing software company that doesn't need to pay dividends. [1 mark for justification of retained profit] However, this only covers 30% of the required amount, so additional finance is needed. [1 mark for analysis]

The company could release some working capital by collecting receivables faster or reducing any excess inventory, perhaps raising £10,000-£15,000. [1 mark for identifying working capital] This would be preferable to selling assets because a software company's equipment (computers, servers) is essential for operations and selling them would reduce productive capacity. [1 mark for justification against asset sales]

The remaining £20,000-£25,000 would need to come from external sources such as a bank loan. [1 mark for recognizing limitations] Using internal sources first is sensible because they are cheaper (no interest) and faster to access, which is important for a young company competing in the fast-moving technology sector. [Additional context for top band]

Example 2: Evaluating retained profit

Question: Jamaican Jerk Ltd, a successful Caribbean restaurant chain with six locations, has £120,000 retained profit. The owners are considering using this money to open a seventh restaurant, which would cost £100,000. However, shareholders are requesting higher dividends.

Evaluate whether Jamaican Jerk Ltd should use retained profit to finance the new restaurant. [8 marks]

Model answer:

Arguments for using retained profit:

Using retained profit would allow rapid expansion without borrowing costs. [1 mark] The restaurant industry has high competition, so opening quickly could secure a prime location before competitors. [1 mark for context/development] With £120,000 available and only £100,000 needed, the company has sufficient funds without requiring external finance, avoiding interest charges that would reduce profits in future years. [1 mark for analysis]

The retained profit has already been taxed, so using it is more efficient than paying dividends (which shareholders then pay tax on) and later raising new equity. [1 mark for developed point] A seventh restaurant should generate additional profits that eventually provide higher dividends than the short-term payment shareholders are requesting. [1 mark for consequence]

Arguments against using retained profit:

Refusing dividend increases may disappoint shareholders and reduce the share price, making it harder to raise equity finance in future if needed for larger expansion. [1 mark] Some shareholders may sell their shares, potentially allowing a hostile takeover. [1 mark for development]

Using nearly all retained profit (£100,000 of £120,000) leaves only £20,000 reserves for emergencies, which is risky in the restaurant industry where revenue can fluctuate seasonally or due to economic downturns. [1 mark for analysis]

Judgment:

The company should use the retained profit for expansion because growing the business creates more long-term value for shareholders than a one-time dividend payment. However, they should consider paying a modest dividend from the remaining £20,000 to maintain shareholder satisfaction. [Conclusion with recommendation]

Example 3: Working capital calculation

Question: Calculate the working capital for a business with current assets of £95,000 (including inventory of £35,000, receivables of £45,000, and cash of £15,000) and current liabilities of £60,000. Recommend one way the business could release £10,000 from working capital. [4 marks]

Model answer:

Working capital = Current assets - Current liabilities [1 mark for formula]

Working capital = £95,000 - £60,000 = £35,000 [1 mark for calculation]

The business could reduce receivables from £45,000 to £35,000 by offering a 2% early payment discount to customers who pay within 10 days instead of the usual 30-day credit period. [1 mark for method] This would convert £10,000 from receivables into cash, releasing it for other uses. [1 mark for explanation] Although the business would lose 2% (£200) in revenue on early payments, it would gain £10,000 immediately that could be used for growth opportunities or paying suppliers. [Development for context]

Common mistakes and how to avoid them

• Confusing internal and external sources — Remember: internal comes from within the business (retained profit, asset sales, working capital), external comes from outside (loans, overdrafts, new shares). If the money requires a bank, investor, or other external party, it's not internal.

• Thinking all businesses can use retained profit — New businesses and loss-making businesses have no retained profit to use. Always check if the business is profitable and established before recommending this source. Start-ups must use external finance or owner's capital.

• Believing working capital is the same as cash — Working capital is current assets minus current liabilities. It includes inventory and receivables, not just cash. To "use" working capital means converting these assets into cash through better management.

• Recommending sale of essential assets — Don't suggest selling machinery or vehicles that the business needs for production. Only recommend selling surplus, obsolete, or unnecessary assets. A bakery shouldn't sell its ovens to raise finance.

• Failing to calculate amounts available — When evaluating sources, consider whether sufficient finance is available. If a business needs £500,000 but has only £50,000 retained profit, this source alone is inadequate and external finance would also be needed.

• Ignoring the context in evaluation questions — The best internal source depends on business type, age, purpose of finance, and amount needed. A two-sentence answer without context scores poorly. Always link recommendations to the specific business situation described in the question.

Exam technique for "Internal sources of finance: retained profit, sale of assets, working capital"

• Command word focus: "Identify" questions (1-2 marks) require naming sources only. "Explain" questions (3-4 marks) need the source plus how it works or one advantage/disadvantage. "Evaluate" or "Discuss" questions (6-12 marks) require balanced arguments for/against with a justified conclusion relating to the specific context.

• Use financial calculations where appropriate: If given figures, calculate working capital or amounts available. Show your formula, calculation, and answer clearly. Even if your final number is wrong, you gain method marks for correct working.

• Apply to context for high marks: Generic answers about retained profit score Level 1 or 2. To reach Level 3, link your points to the specific business, industry, size, or situation in the question. Example: "Retained profit suits this profitable manufacturing business because..." not just "Retained profit has no interest charges."

• Compare sources in evaluation questions: Don't just discuss one source. Explain why retained profit is better than asset sales for this particular business, or why working capital is insufficient compared to external loans. Comparative analysis demonstrates higher-order thinking and accesses top mark bands.

Quick revision summary

Internal sources of finance come from within the business. Retained profit is accumulated earnings kept in the business rather than distributed as dividends — it's free and flexible but only available to profitable companies. Sale of assets converts owned items into cash quickly but is one-time only and may reduce capacity. Working capital can be released by managing inventory, receivables, and payables more efficiently, though amounts are limited. Choose between sources based on business age, amount needed, urgency, and asset availability. Internal finance avoids interest and ownership dilution but may be insufficient for large projects.