Factors Affecting the Choice of the Source of Funds

A firm's financial needs are of different types — long-term, short-term, fixed and fluctuating — so businesses use different sources to raise funds. Short-term borrowing has the advantage of lower cost (less idle capital), while long-term borrowing is a necessity on many grounds, and equity capital has its own role in the corporate scheme. Because no source is free of limitations, it is wise to use a combination of sources rather than relying on a single one. Choosing that combination is a complex decision shaped by the following factors:

• (i) Cost: Consider both the cost of procuring funds and the cost of using them when deciding on a source.
• (ii) Financial strength and stability of operations: The firm must be financially sound enough to repay principal and interest. When earnings are unstable, fixed-charge funds like preference shares and debentures should be chosen carefully, as they add to the financial burden.
• (iii) Form of organisation and legal status: The form of the business influences the choice — for example, a partnership firm cannot issue equity shares, since only a joint stock company can.
• (iv) Purpose and time period: Match the source to the duration and use. A short-term need can be met by low-cost trade credit or commercial paper; long-term finance is better met by shares and debentures. A long-term expansion plan should not be financed by a bank overdraft that must be repaid in the short term.
• (v) Risk profile: Evaluate each source for the risk involved. Equity carries the least risk — share capital is repaid only at winding up and dividends need not be paid if there are no profits. A loan, by contrast, has a fixed repayment schedule for principal and interest, and interest must be paid whether the firm profits or loses.
• (vi) Control: A source may affect the owners' control over management. Issuing equity shares can dilute control (they carry voting rights), and financial institutions may take control of assets or impose conditions in a loan agreement. The firm must choose keeping in mind how much control it is willing to share.
• (vii) Effect on creditworthiness: Dependence on some sources can affect the firm's creditworthiness. For example, issuing secured debentures may hurt the interest of unsecured creditors and reduce their willingness to lend further. …