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FACTORS THAT AFFECT THE CHOICE OF APPROPRIATE SOURCE OF BUSINESS FINANCE

Factors affecting the choice of the source of business finance

Business finance - unifinn

Source of business finance

TABLE OF CONTENTS

  1. Meaning of business finance
  2. Types of the needs of business finance
  3. Factors affecting the choice of the source of business finance
    1. Cost of the funds
    2. Financial stability and strength of business operations
    3. Positive cash flow from operations
    4. Form of organization and legal status
    5. Purpose and time period
    6. Risk profile
    7. Control
    8. Effect on credit worthiness
    9. Flexibility and ease
    10. Tax benefits
1. Meaning of Business Finance

Business is concerned with the production and distribution of goods and services for the satisfaction of the needs of society. For carrying out various activities, business requires money. Finance, therefore, is called the lifeblood of any business. The requirement of funds by a business to carry out its various activities is called business finance. 

Business Finance means the funds and credit employed in the business. A business cannot function unless adequate funds are made available to it. The initial capital contributed by the entrepreneur may not always be sufficient to take care of all financial requirements of the business. A business person, therefore, has to look for different and alternative sources from where the need for funds can be met.

2. Types of business finance needs

The financial needs of a business are of different types – long-term, short the term, fixed and fluctuating. Because of the different needs, business firms resort to different types of sources for raising funds. Short-term borrowings offer the benefit of reduced cost due to the reduction of idle capital, but long–term borrowings are considered a necessity on many grounds. Similarly equity capital has a role to play in the scheme for raising funds in the corporate sector.

3. Factors affecting the choice of the source of business finance

As no source of funds is devoid of limitations, it is advisable to use a combination of sources, instead of relying only on a single source. A number of factors affect the choice of this combination, making it a very complex decision for the business. The factors that affect the choice of source of finance are briefly discussed below:

 

a) Cost of the funds

There are two types of cost viz., the cost of procurement of funds and the cost of utilising the funds. Both these costs should be taken into account while deciding about the source of funds that will be used by an organisation. The business should generate the required operating profit margin to cover the additional cost of funds. The cost of debt financing can be shown in the income statement as an expense whereas the cost of equity funding will not be reflected in the profitability computations because the same is in the form of dividends.

b) Financial strength and stability of operations

The financial strength of a business is also a key determinant. In the choice of source of funds, the business should be in a sound financial position so as to be able to repay the principal amount and interest on the borrowed amount. When the earnings of the organisation are not stable, fixed-charged funds like preference shares and debentures should be carefully selected as these add to the financial burden of the organisation.

Recommended read: All about bridge financing

c) Positive cash flow from operations

The business needs to ensure that there will be enough positive operational cash flows to service the repayment of the financed amount. 

d) Form of organisation and legal status

The form of business organisation and status influences the choice of a source for raising money. A partnership firm or a limited liability company (LLP), for example, cannot raise money by the issue of equity shares. The equity shares can be issued only by a joint-stock company or a corporate entity.

e) Purpose and time period

Businesses should plan according to the time period for which the funds are required. A short-term need for example can be met through borrowing funds at a low rate of interest through trade credit, commercial paper, etc. For long-term finance, sources such as the issue of shares and debentures are more appropriate.

Similarly, the purpose for which funds are required needs to be considered so that the source is matched with the use. For example, a long-term business expansion plan should not be financed by a bank overdraft or any other working capital facilities. These short-term facilities will be required to be repaid in the short term. To meet the short-term working capital requirements, the business must choose a working capital facility. Long-term expansion or investments in capital expenditure should be financed through a long-term loan or equity financing would be better to avoid liquidity mismatches in the business.

f) Risk profile

The business should evaluate each of source of finance in terms of the risk involved. For example, there is the least risk in equity as the share capital has to be repaid only at the time of winding up and dividends need not be paid if no profits are available. A loan, on the other hand, has a repayment schedule for both the principal and the interest. The interest is required to be paid irrespective of the firm earning a profit or incurring a loss.

g) Control

A particular source of the fund may affect the control and power of the owners on the management of a firm. Issue of equity shares may mean dilution of the control. For example, as equity shareholders enjoy voting rights, financial institutions may take control of the assets or impose conditions as part of the loan agreement. Thus, the business firms should choose a source keeping in mind the extent to which they are willing to share their control over the business.

h) Effect on credit worthiness

The dependence of businesses on certain sources may affect their creditworthiness in the market. For example, the issue of secured debentures may affect the interest of unsecured creditors of the company. This may adversely affect their willingness to extend further loans as a credit to the company.

i) Flexibility and ease

Another aspect affecting the choice of a source of finance is the flexibility and ease of obtaining funds. Restrictive provisions, detailed investigation and documentation in case of borrowings from banks and financial institutions for example may be the reason that a business organisation may not prefer it if other options are readily available.

j) Tax benefits

Various sources may also be weighed in terms of their tax benefits. For example, while the dividend on preference shares is not tax-deductible, interest paid on debentures and loans is tax-deductible. Therefore, this may be preferred by organisations seeking a tax advantage.

Read more on alternative financing sources:

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