8. Factors Affecting Choice of Finance

1. Time period
   • Short vs long term needs.

When businesses consider financing options, they must take into account how long they will need the funds. This falls into two categories: short-term and long-term needs.

• Short-term finance is often needed for immediate expenses such as inventory, salaries, and operational costs, usually lasting up to one year.
• Long-term finance is aimed at substantial investments, like purchasing equipment or expanding operations, lasting beyond five years.

Think of a small bakery. If they need money to buy flour and sugar to make pastries for the next week, they require short-term finance. However, if they plan to buy a new oven that will last many years, that investment requires long-term finance.

2. Cost of finance
   • Interest rate, cost of raising capital.

The cost of financing is another crucial factor. Businesses must consider how much it will cost them to obtain funds. This includes interest rates, which are the charges for borrowing, and any other costs associated with raising capital, like fees or charges. Lower cost options are often more attractive, as they do not reduce profits as much.

Imagine wanting to borrow $100 from a friend. If your friend asks for$10 for a week, the cost of finance (the interest cost) is 10%. If a bank offers the same amount for only $5, it’s a better deal, showing how costs can differ between sources.

3. Control
   • Owners may avoid equity if they don’t want to dilute control.

Business owners often want to maintain a level of control over their operations. If they choose to issue equity or sell shares to raise funds, they may dilute their ownership and control. This means they would have to share decision-making with new shareholders. Hence, some owners prefer to use other financing sources that do not require giving away ownership.

Consider a restaurant owner who wants to expand. If they bring in investors by selling shares, those investors will want a say in how the restaurant is run. If the owner values maintaining complete control, they may prefer a bank loan instead.

4. Risk
   • High debt increases financial risk.

The level of risk associated with different financing options is another key consideration. Taking on high levels of debt can be risky, especially if the business struggles to generate sufficient revenue to cover repayments. If a company cannot pay its debts, it risks default and potential bankruptcy.

Think of a person who buys a car on a loan. If they can’t keep up with their payments due to job loss, they risk losing their car. Similarly, a company must remember that high debt can threaten its survival if it generates inadequate income.

5. Availability
   • Some sources are available only to large businesses.

The availability of financing sources can vary significantly based on the size of the business. Larger firms often have access to more financing options, including favorable interest rates and larger sums. In contrast, small businesses might face barriers to accessing certain types of funding, making it harder for them to secure the necessary capital.

Imagine a startup looking for funding. They might struggle to get a loan from a bank because they lack a proven track record. In contrast, an established corporation might quickly secure funds due to its solid history and reputation.

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