Q.What are the various factors that determine the selection of sources of finance?

No single source of finance suits every need. A business selects a source after considering cost, risk, the amount and time period of the funds, the purpose, the control the owners want to keep, the firm's creditworthiness, tax effects, flexibility and conditions in the money/capital market. The aim is the right balance of owned funds and borrowed funds at the lowest cost and risk.

Factors determining the selection of sources of finance

• Cost: Both the cost of raising the funds and the cost of using them (interest, dividend) must be compared; the cheaper source is preferred.
• Financial strength and stability: A financially strong firm can raise borrowed funds easily; a weak firm should rely more on owned funds to stay stable.
• Form of organisation and legal status: A sole trader or partnership cannot issue shares or debentures, whereas a company can; the form of business limits the sources available.
• Purpose and period: Funds needed for a long period or for fixed assets are raised through long-term sources (shares, debentures, term loans); short-term needs are met by trade credit, bank overdraft, etc.
• Risk: Borrowed funds carry a fixed repayment and interest burden, so they are riskier; owned funds carry less risk.
• Degree of control: Issuing fresh equity dilutes the control of existing owners, so those who wish to retain control prefer loans or preference shares.
• Amount of funds required: A large requirement may need shares/debentures; a small requirement can be met from retained earnings or short-term sources.
• Flexibility and ease: A source that can be raised and repaid easily, without too many conditions, is preferred. …