Factors to consider when choosing a source of finance

• There are a lot of things a business needs to consider before settling on the best source of finance to use
• Some these factors include:

1 The amount required

• Some sources of finance are ill suited for raising large amounts of money for example bank overdrafts have a limit as to how much can be withdrawn
• In this instance it would be best to use sources such as dentures, share capital or long term leases
• Some sources of finance are also ill suited for raising small amounts of money for example it would be imprudent to issue new shares to finance the day to day operations of the business such as paying wages
• It would be best in such instances to use sources such as a bank overdraft

2 Type of expenditure/Purpose for which the capital is required

• Long term sources of finance are better suited to finance capital expenditure projects for example building a new factory plant
• Short term sources of finance are more suited to finance revenue expenditure projects such as paying suppliers

3 The length of time for which the money is required

• Where the money will be tied up in the project for a long period of time it would be prudent to use long term sources of finance such as debentures, shares and long term loans for example when raising money to build new factory plant
• If the money is required only for a relatively short period of time it would be best to use short term sources of finance such as overdrafts

4 The size, status and ability of the business to borrow

• If the business is large and has collateral security which it can use to borrow then it can consider borrowing from financial insitutions
• If the business is smaller and lacks the collateral security to borrow, borrowing might not be an option for them

5 The business’s current level of gearing

• Gearing refers to what proportion of a business’s assets are paid for by debt finance
• A highly geared business should consider using equity finance instead so as to reduce their level of risk
• A lowly geared business would do well to consider debt finance

6 The business’s level of reserves and profits

• Some businesses transfer their yearly profits to special/General Reserves
• This is a form of ploughing back profits but holding it in special “funds”
• If a business has say a Fixed Asset Replacement Reserve it can use that instead of looking for external sources of finance
• A highly profitable business can also make use of retained earnings to finance its operations and projects

7 The cost of the source of finance

• The available sources of finance must be ranked according to their capital cost
• It is best to go with the choice of finance that the business can afford

To access more topics go to the O Level Business Notes page.