Factors Affecting the Choice of Source of Finance

No single source of finance is ideal for every business or every situation, and a firm's finance manager must weigh several factors before deciding which source, or combination of sources, to use for a given requirement. These factors help explain why two businesses with similar needs might still choose very different sources of finance.

The cost of raising and servicing funds is one of the most important considerations. Every source of finance carries some cost — equity shares involve the expectation of dividend and a share in future growth, debentures and loans involve a fixed rate of interest, and even trade credit can carry a hidden cost if a cash discount for early payment is foregone. A business generally compares the effective cost of each available source, including any issue expenses, brokerage or processing charges, before deciding which is the most economical for its situation.

The period and purpose for which funds are needed strongly guides the choice. A firm that needs money to buy a permanent fixed asset, such as a factory building, will look towards long-term sources like equity, preference shares or long-term loans, because using a short-term source for a long-term need would create a mismatch and force frequent, disruptive refinancing. Conversely, a need to bridge a short gap in working capital, such as financing a season's extra purchase of raw material, is better met by a short-term source like trade credit or a bank overdraft rather than by locking up long-term capital.

The risk involved is another key factor. Borrowed sources such as debentures and loans carry fixed obligations of interest and repayment that must be met regardless of how the business performs, so relying heavily on borrowed funds increases financial risk, particularly for a business with fluctuating or uncertain income. Owned sources like equity capital do not create this fixed burden, since dividend is paid only when the company earns sufficient profit and chooses to distribute it, which makes owned capital a safer cushion, especially in the early or uncertain years of a business.

The effect on ownership and control is a factor that particularly concerns the existing owners of a business. Raising fresh equity capital brings in new shareholders and can dilute the proportion of ownership, and therefore the voting power, held by the founders or promoters. A business that wishes to preserve tight control in the hands of existing owners may prefer to raise funds through borrowing or preference shares, since neither ordinarily carries voting rights, even though this increases the fixed financial obligations of the business.

Flexibility is also important — some sources, like a bank overdraft or trade credit, can be adjusted up or down relatively easily as the business's needs change from month to month, while other sources, such as debentures or public deposits raised for a fixed term, commit the business to a rigid schedule of interest and repayment that cannot easily be altered once the funds are raised. …