The Best Choice of Finance (DP IB Business Management)

Revision Note

Flashcards

Choosing the most Appropriate Source of Finance

  • Businesses need to investigate and select a combination of sources of finance that are most suitable for their particular needs

  • Not all sources of finance are available to every business

    • A poor credit history may exclude a business from applying for some types of loans or using an overdraft

    • Business start ups are unlikely to be able to access sources of finance such as trade credit as may not have yet established a trading record and may be viewed as too risky

Diagram: factors affecting the choice of finance

Several factors affect the suitability of the choice of finance such as the timescale, the cost, the purpose, the legal structure of the business, the willingness to relinquish control, and the level of existing debt
A range of factors will affect the most suitable sources of finance for a business

  1. Timescale

  • Short-term sources of finance will be needed to meet unexpected costs or to pay bills and suppliers

    • These are likely to be relatively small amounts and are rarely needed beyond a year

  • Longer-term sources of finance will be needed to fund the purchase of non-current assets such as buildings and other types of capital equipment

    • These are likely to be large sums that may be required for a significant period of time

Diagram: short-term and long-term sources of finance

Long-term and short-term sources of finance
Long-term and short-term sources of finance

2. Legal structure

  • Sole traders, partnerships and small private limited companies usually have a more limited range of sources of finance as they are seen as having a greater lending risk

    • Interest rates on loans are likely to be higher as these businesses tend to lend smaller amounts than public limited companies and are not in a position to approach specialist lenders

  • Public limited companies are able to access a wide selection of sources of finance and are able to provide collateral as security for lenders

3. Cost

  • Interest payable on loans can add a significant cost to the use of some sources of finance

    • Variable interest rates change during the borrowing term, which may make financial planning difficult

    • Fixed interest rates remain constant for the period of the loan and for this reason they are usually higher than variable rates

  • The cost of selling shares in public limited companies is an expensive process

    • Flotation is usually carried out by merchant banks, which charge a premium price  for their specialist services

    • Selling shares through a rights issue may reduce the amount of share capital raised, as they are usually sold at a discount to existing shareholders

4. Control

  • Selling shares or raising venture capital can result in some loss of control for business owners

    • Smaller businesses may have to accept the terms of more powerful suppliers or business angels as they have little power to negotiate

5. Purpose of the finance

  • Certain sources of finance have particular uses

    • A mortgage is the most appropriate type of lending to purchase land or property

    • Overdrafts are flexible and are best used for short-term working capital requirements

6. The level of existing debt

  • Highly geared businesses already make use of significant amounts of debt

  • Lenders and investors may be reluctant to provide further funds due to the level of risk the business presents

  • Businesses with a poor or no borrowing history may not meet credit score requirements and would be excluded from most types of credit

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