Criteria Used to Choose Sources of Finance

When making its financing decisions, a company considers various factors that determine their choices in terms of sources of finance. Firms have to make a choice between internal and external sources, debt and equity, and/or where to get the funding. To make such decisions, financial managers should be aware of their current financing needs, financial position, availability of funds, cost of financing, leverage position, business risks, security, duration of loan if any, and other factors.

The criteria used can also be defined as the factors to consider when choosing the source of finance. The following factors or criteria must be considered before choosing the best source of finance to use:

  • The Amount Required/Capital Requirement: Before choosing a source of finance, the company should first assess its financial requirements to determine the amount of funding required. Some funding sources require a large amount of money to be raised. For instance, share capital is appropriate when raising a large amount of capital. Debentures and venture capital are other sources of finance that are suitable for raising large amounts of capital to meet long term investment needs. On the other hand, short term loans and bank overdrafts are used for small capital requirements, especially when funding working capital or raising money for daily business operations.
  • Purpose/Type of Expenditure: Financing decisions are affected by the type of expenditure of the organization. Finance managers should consider the type of expenditure or the purpose for which the funds are raised. Long term sources of finance are better suited to finance capital expenditure projects for example building a new textile factory. On the other hand, Short term sources of finance are more suited to finance operations such as paying suppliers.
  • Time/Duration: The matching accounting principle states that assets and liabilities should be matched based on the maturity period of assets. When a company decides to raise funds, they must consider the timelines involved or duration of the funding. For instance, the company can decide to borrow a bank loan that has a duration of 10 years to finance a long term investment project. It is not prudent to borrow a long term debt to acquire an asset that has a short maturity period.
  • Cost: The cost of capital is also an important criteria or factor to be considered when choosing an appropriate source of finance. The cost of capital becomes a factor in deciding which financing track to follow: debt, equity, or a combination of the two. For example, the cost of accessing long term loan is the interest charged by the bank. There are also transaction costs and time involved in acquiring the loan. Another cost is the collateral required by the before acquiring a loan. A company that is in its early stage may not have enough assets to be used as collateral for loans, which means that they will choose equity and/or other alternative sources of finance.
  • Risk: Every investment involves risks. A company risks losing money and not being able to pay back debts, which calls for equity as an alternative source of capital. Even so, equity capital has its own risks involved such as market risks and loss of share value, which reduces the company’s returns in the long run.
  • Control: When a company acquires funds from an external source, it is bound to lose control of some business operations or management. The firm may lose more control in one source of finance than another. For instance, the company loses control of its business and when equity capital and venture capital are involved. However, the company retains much control of its operations when using debt capital. Companies must decide how much control they are willing to lose in order to acquire the right amount of capital.

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