The Best Choice of Finance (DP IB Business Management)

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

  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

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