What you'll learn
A business needs finance to start, to operate day to day and to grow, and the central skill in this topic is matching the source to the use. Borrowing over twenty years to fund a month's wages is as wrong as funding a factory from an overdraft, and examiners test that matching far more than they test definitions. This guide covers internal and external sources, the short, medium and long-term distinction, equity against debt finance, the factors determining which source suits a given need, the cost and risk of each, and the sources available to Caribbean businesses in particular. It sits in Unit 1 Module 3.
Key terms and definitions
Capital expenditure — spending on non-current assets that will be used over several years.
Revenue expenditure — spending on day-to-day operating costs.
Working capital — current assets less current liabilities; the finance available for day-to-day operations.
Internal finance — funds generated from within the business.
External finance — funds raised from outside the business.
Retained profit — profit kept in the business rather than distributed to owners.
Share capital — finance raised by issuing shares, giving the holder part-ownership.
Equity finance — finance from owners, carrying no obligation to repay.
Debt finance — borrowed finance that must be repaid with interest.
Overdraft — a facility allowing a business to draw more from its bank account than it holds.
Trade credit — the period a supplier allows before payment is due.
Debt factoring — selling unpaid invoices to a third party for an immediate reduced sum.
Leasing — paying to use an asset without owning it.
Hire purchase — paying for an asset in instalments, owning it after the final payment.
Debenture — a long-term loan to a company, usually at a fixed rate of interest.
Venture capital — investment in a high-risk business in exchange for a stake in it.
Gearing — the proportion of a business's finance that is borrowed rather than owned.
Collateral — an asset pledged as security for a loan.
Core concepts
Matching the source to the use
The single most examined principle: the term of the finance should match the life of what it funds.
Capital expenditure — premises, machinery, vehicles — should be funded from long-term sources, because the asset generates returns over years and repayment should be spread over the same period.
Revenue expenditure and working capital — wages, stock, utilities — should be funded from short-term sources, because the need is temporary and recurring.
Getting this wrong causes real damage in both directions. Funding a building from an overdraft means the bank can demand repayment at any time on an asset that cannot be quickly sold. Funding a month's wages from a ten-year loan means paying interest for a decade on money needed for weeks.
Internal sources
Retained profit is profit kept in the business. It has no interest cost, requires no security and involves no loss of control, which makes it the cheapest source available. Its limits are real: only a profitable business has any, it may be needed elsewhere, and retaining it reduces the return to owners, who may object.
Sale of assets converts an unused or surplus asset into cash. It works for genuinely surplus assets; selling something the business needs, or selling at short notice under pressure, usually realises less than the asset is worth.
Sale and leaseback sells an asset and leases it back, releasing cash while retaining use — at the cost of rental payments and of losing any future gain in the asset's value.
Better working capital management — collecting from customers sooner, holding less stock, negotiating longer to pay suppliers — releases cash already inside the business. It is the most overlooked source and often the cheapest, but each lever has a limit: pressing customers can lose them, and holding too little stock risks running out.
Short-term external sources
Overdraft. Flexible, arranged quickly, and interest is paid only on the amount used. It is expensive per day, is usually repayable on demand, and is unsuited to anything but short-term gaps.
Trade credit. Effectively an interest-free loan from suppliers, and the most widely used short-term source. Exceeding the agreed period damages the relationship, risks supply being withheld, and forfeits any early-payment discount.
Debt factoring. Sells unpaid invoices for an immediate sum below their face value, converting receivables into cash quickly. The discount is the cost, and using a factor can signal to customers that the business is short of cash.
Medium-term external sources
Bank loan. A fixed sum repaid over an agreed period, usually with interest and usually secured on an asset. Repayments are predictable, which aids planning; the business must meet them regardless of how trading goes, and security may be lost on default.
Hire purchase. Instalment payment with ownership passing at the end. The asset is available immediately without full payment; the total cost exceeds the cash price.
Leasing. Payment for use without ownership. It avoids a large initial outlay, maintenance is often included, and equipment can be updated at the end of the term — but over a long period it costs more than buying, and the business never owns the asset.
Long-term external sources
Share capital. Issuing shares raises finance with no obligation to repay and no interest. The costs are dilution of ownership and control, an expectation of dividends, and — for a public issue — substantial expense and disclosure. Only companies can use it.
Debentures and long-term loans. Large sums over long periods at a stated interest rate. Ownership is not diluted, but interest must be paid whatever the trading position, and the borrowing raises gearing.
Mortgage. A long-term loan secured on property, suited to purchasing premises.
Venture capital. Investment in a high-risk business in exchange for a stake, often with expertise and contacts alongside the money. The cost is a significant share of ownership and usually some control, and venture capitalists expect an exit.
Government grants and development finance. Often targeted at particular sectors, regions or activities such as export or training. Grants generally need not be repaid, which makes them attractive, but they are competitive, conditional and slow.
Equity against debt
Equity need not be repaid and carries no interest, so it does not threaten a business in a bad year. It dilutes ownership and control, and shareholders expect returns.
Debt leaves ownership intact and interest is a known cost, but it must be serviced whatever happens and it raises gearing. A highly geared business is more vulnerable to a downturn or an interest-rate rise, because interest must be paid before anything else.
The trade-off is between risk and control: debt keeps control but adds risk; equity reduces risk but surrenders control. Which matters more depends on how stable the business's cash flows are and how much the owners value independence.
What determines the choice
Purpose and term — matching, as above. Amount — small sums from an overdraft, large sums from long-term sources. Cost — interest rate, fees, and the return shareholders will expect. Legal form — a sole trader cannot issue shares. Existing gearing — a heavily borrowed business may be refused more debt. Security available — lenders require collateral, and a service business with few assets has little. Control — owners unwilling to dilute must prefer debt. Speed — an overdraft can be arranged in days, a share issue takes months. Stage of the business — start-ups have no retained profit and no track record, which is why they rely on owner savings, family, and sometimes venture capital.
Caribbean context
Access to finance is a recurring constraint for small regional businesses, and the reasons are structural rather than incidental.
Commercial bank lending frequently requires collateral that a young or service-based business does not hold. Credit unions are significant across the region and lend to members underserved by commercial banks. National development banks and agencies provide targeted lending, often for agriculture, manufacturing or small enterprise, at concessionary rates. The Caribbean Development Bank and similar institutions support development lending at the regional level.
Regional stock exchanges operate in several territories and allow larger companies to raise equity publicly, though the number of listed companies is small. A substantial informal sector operates outside formal finance entirely, relying on personal savings and family lending, which limits how far those businesses can grow.
Worked examples
Example 1: Matching source to need (calculation)
Question: "A manufacturer needs $600,000 for new machinery expected to last ten years, and $40,000 to cover a seasonal stock build-up lasting three months. Recommend a source for each and justify." (12 marks)
Working. For the machinery, a ten-year bank loan or a mortgage-style facility matches the asset's life. At, say, 9% on a reducing balance the first year's interest is roughly:
$600,000 × 9% = $54,000 in year one, falling as principal is repaid.
Leasing is the alternative: no large initial outlay and maintenance often included, but over ten years the total paid exceeds the purchase price and the business never owns the machine.
For the seasonal stock, an overdraft of $40,000 for three months at, say, 14%:
$40,000 × 14% × (3 ÷ 12) = $1,400
Answer. Loan or lease for the machinery, overdraft for the stock. The justification is what earns the marks: the overdraft is flexible and charged only on what is used, so it suits a temporary need, while committing a ten-year loan to a three-month requirement would mean paying interest for a decade on money needed for a quarter. Conversely, funding the machinery on overdraft would leave a repayable-on-demand facility secured against an asset that cannot be sold quickly.
Example 2: Gearing
Question: "A business has $400,000 of share capital and reserves and $600,000 of long-term debt. Calculate its gearing and comment." (8 marks)
Working.
Total long-term finance = $400,000 + $600,000 = $1,000,000 Gearing = debt ÷ total long-term finance = $600,000 ÷ $1,000,000 = 60%
Comment. Above 50% is conventionally regarded as highly geared. Interest must be paid before any return to owners, so in a downturn the business is exposed, and a rise in interest rates raises the cost of servicing the debt. Further borrowing is likely to be refused or offered only at a higher rate. If expansion finance is needed, equity is the safer route despite diluting control — and note that gearing of 60% is not automatically bad, since a business with stable, predictable cash flows can service debt that would endanger a volatile one.
Example 3: Evaluating trade credit
Question: "A supplier offers 2% discount for payment within 10 days, or full payment in 30 days. Advise a business with an overdraft costing 15% a year." (10 marks)
Working. Taking the discount means paying 20 days earlier to save 2%.
Saving = 2% for 20 days Annualised ≈ 2% × (365 ÷ 20) = 36.5% a year
Answer. The discount is worth roughly 36.5% annualised, well above the 15% cost of the overdraft, so the business should borrow on overdraft if necessary and take the discount. Add the qualification that this holds only if the overdraft facility is available and the business is not already at its limit, and that trade credit taken to its full term is otherwise an interest-free source that should not be given up lightly.
Common mistakes and how to avoid them
Failing to match term to use. This is the principle most heavily examined.
Calling retained profit free. It has no interest cost but does have an opportunity cost to owners.
Confusing leasing with hire purchase. Hire purchase ends in ownership; leasing does not.
Saying a sole trader can issue shares. Only companies can.
Treating high gearing as automatically bad. It depends on the stability of cash flows.
Ignoring security. A business with few assets cannot borrow as readily whatever its profits.
Recommending a source without justifying it. The reasoning carries the marks.
Inventing interest rates and presenting them as fact. State an assumed rate explicitly as an assumption.
How this links to your Internal Assessment
Establish how your chosen business is actually financed, and expect the answer to be less formal than the textbook. Many small Caribbean businesses run on owner savings, family lending, trade credit and retained profit, and describing that honestly is better material than listing sources the business does not use.
The productive line is to connect finance to a constraint you can observe. If the business cannot expand, ask what it would need and why it cannot raise it — lack of collateral, existing gearing, or unwillingness to dilute ownership are all plausible and all analysable. If it holds more stock than seems efficient, working capital is tied up and that has a cost.
Be careful with confidentiality. Owners may share figures in confidence or not at all, and a private company publishes nothing. Where you cannot obtain figures, say so in your limitations rather than estimating and presenting the estimate as data.
Exam technique for sources of finance
Match the term of the source to the life of what it funds, and say why.
Justify every recommendation; the reasoning earns more than the choice.
Distinguish internal from external and short from long term explicitly.
Show calculations in full, with the formula stated before the numbers.
State any interest rate you assume as an assumption rather than a fact.
Consider legal form, security, gearing and control, not only cost.
Use regional sources where relevant: credit unions, development banks, regional exchanges.
Watch the command word: identify wants the source, explain wants how it works, evaluate and recommend want a justified judgement.
Quick revision summary
Finance should be matched to its use: capital expenditure from long-term sources, working capital from short-term ones, because mismatching either way is costly. Internal sources — retained profit, sale of assets, sale and leaseback, and better working capital management — carry no interest and no dilution but are limited by what the business has generated. Short-term external sources include the overdraft, flexible but repayable on demand; trade credit, effectively interest-free and the most widely used; and debt factoring, which converts invoices to cash at a discount. Medium-term sources include bank loans with predictable repayments, hire purchase ending in ownership, and leasing which never does. Long-term sources include share capital, which needs no repayment but dilutes control; debentures and long-term loans, which preserve ownership but must be serviced regardless of trading; mortgages secured on property; venture capital, which brings expertise at the cost of a substantial stake; and government grants, which are attractive but competitive and conditional. Equity reduces risk and surrenders control while debt preserves control and raises gearing, and gearing above 50% is conventionally high though its danger depends on the stability of cash flows. Choice depends on purpose, amount, cost, legal form, existing gearing, available security, control and speed. In the Caribbean, collateral requirements, credit unions, national development banks, the Caribbean Development Bank, small regional stock exchanges and a large informal sector all shape what is actually available.