Choosing an Appropriate Source of Finance

With so many sources of finance available — owned and borrowed, long-term, medium-term and short-term — the concluding idea of this AP Board Intermediate Commerce chapter is that a firm cannot pick any source at random; it must match the source to the purpose for which the money is needed.

The single most important guiding rule is that the period for which a source of finance is available should match the period for which the funds are actually required. Fixed assets, which stay in the business for many years, should be financed from long-term sources such as equity, preference capital, retained earnings, debentures or long-term loans; financing a factory building with a short-term bank overdraft, for instance, would leave the firm exposed to a demand for immediate repayment long before the asset itself has paid for itself through earnings. Conversely, a genuinely short-term, recurring need — such as holding a season's extra stock — is best met through trade credit, an overdraft or cash credit, since tying up expensive long-term capital in a need that reverses itself within months would be wasteful.

Beyond period-matching, a firm weighs several further factors before choosing a source. The cost of the source matters, since owned funds like equity involve no fixed charge but are usually costlier to raise, while borrowed funds carry a fixed but often lower interest cost. The risk involved matters too, since heavier use of borrowed funds raises the fixed burden of interest and repayment that the firm must meet even in a poor year, whereas owned funds carry no such compulsion. The effect on control and ownership must be considered, since fresh equity issues can dilute existing shareholders' voting power while preference capital, debentures and loans generally do not. The purpose and urgency of the funds, the current state of the capital market, government regulations governing the particular source, the flexibility a source offers for repayment or conversion, and the firm's own credit standing with lenders and investors alike are all part of a sound financing decision. …