Finance managers need to consider many factors when it comes to making the strategic finance choice between alternative sources of finance.
All sources of finance serve the same purpose which is to fund business activity. And businesses can obtain their finance from a range of sources including internal sources of finance and external sources of finance. However, different sources of finance are used in different business situations.
Effective financial management by managers is necessary for the successful daily running of a business, medium-term growth and long-term prosperity, profitability. This is important because when the business is unable to immediately repay its debts to creditors serious cash-flow problems emerge which may cause liquidation or even bankruptcy. Also, when the business is not profitable, it will not have any retained fund to grow.
Therefore, managers must be fully aware that the strategic choice and control of finance will have impact on the firm’s financial performance. Hence, an effective business strategy must consider the various sources of finance to ensure there are sufficient funds to run the business organization in the short-term, medium-term and long-term.
The degree of success of the firm’s business strategy is presented in quarter and annual final accounts including Profit and Loss Account (P&L), Balance Sheet and Cash Flow Statement.
What influence the choice of finance?
The appropriateness of the different sources of finance depends on several factors including the purpose of finance, cost of finance, duration of finance, required amount of finance, type of the business organization, size and status of the business, gearing level, flexibility and external influences.
1. Purpose of finance
The choice of finance depends on what the money is intended for. Finance managers should match the sources of finance to the need for it. Some sources of finance are usually only available for very specific uses.
A. For daily running of the business
This includes short-term purposes below one year. Overdrafts are more suitable for improving Working Capital by injecting some quick cash to pay utility bills. Trade credit is advisable when a firm needs to acquire some raw materials when demand for products suddenly increases, but the firm does not have enough money in its current account. Debt factoring can be used to pay current creditors. The owners can also ask family and friends for help or inject personal funds to fix any liquidity problems. Short-term bank loan can help when a company needs extra money to cover the month’s wages while it waits for customers to pay.
B. For medium-term projects
This includes medium-term purposes between one and five years. Leasing might be more appropriate for financing expensive equipment that needs to be replaced often due to technological hardware upgrades and regular software updates. Leasing is only available for financing physical assets such as cars, machinery and property. Retained profits or personal funds could be used to finance a major advertising campaign.
C. For permanent investments in Fixed Assets
This includes long-term purposes above five years. Mortgages are only available for the purchase of property. Sale of unwanted Fixed Assets such as idle plots of land, unused machinery or empty buildings can pay for purchasing more suitable premises and the newest equipment. Venture Capital (VC) can be raised by start-ups or growing small and medium businesses offering innovative technology. Internal long-term sources can be gained either by reductions in Working Capital (releasing finance tied up in Current Assets such as permanent reductions in inventory levels), or through retaining more profits by reducing dividends paid out to shareholders.
2. Cost of finance
Finance managers need to consider the purchase cost of assets. Obtaining finance for a business is never free. It is because even internal sources of finance have an opportunity cost, administrative fees and maintenance charges.
A. Cheap finance
Internal sources of finance have the lowest cost. It is because internal money already belongs to the business, and does not increase the liabilities or debts of the firm. It includes money raised from the owner’s savings, selling business’s own assets or from retained profits earned by the business at the end of the fiscal year and ploughed back for future growth.
B. Expensive finance
Long-term external sources of finance have the highest cost to the business. Debt finance does not belong to the business, and does increase the liabilities or debts of the firm. Borrowed finance such as mortgages for the purchase of land and buildings is expensive during a period of rising interest rates. Equity finance is also expensive because a stock exchange flotation can cost millions of dollars in fees and promotion of the share sale.
3. Duration of finance
The business needs to plan carefully to decide how long it will need the finance for.
Short-term finance should be borrowed to pay for short-term needs. And long-term finance should be borrowed to pay to long-term needs. Otherwise, it becomes risky and not effective to mix them up.
The shorter the period of time the finance is needed, the more expensive it is. The longer the period of time the finance is needed, the cheaper it is. This is because interest payments snowball over time making borrowing costlier.
A. Short-term finance
In the short-term, while an overdraft is the most flexible solution it is also the most expensive one as overdrafts come with high interest rates, much higher than that of a regular bank loan. If finance is needed to help fund Working Capital, then short-term sources such as trade credit or debt factoring are appropriate.
B. Long-term finance
Long-term loans, mortgage and selling bonds (debentures) are suitable for purchases of assets to be used in the long-term. Also, share issues will be appropriate to raise permanent capital for global expansion when a business aspires to become a multinational company.
4. Required amount of finance
The amount of finance needed for funding daily operations of the business, or buying Fixed Assets with a relatively low value such as vehicles, will be small. While the amount of long-term finance needed for acquiring or taking over another firm, or buying Fixed Assets with a relatively high value such as new machinery for the assembly line, will be large.
A. Small amounts of finance
A small amount of money needed can be raised from the owner’s personal funds, retained profits or an overdraft. A smaller amount might also be financed through short-term bank loans, or leasing and hire purchase. Reducing trade receivables’ payment period could be used to raise small sums as well.
B. Large amounts of finance
A large amount of money needed can be raised through an Initial Public Offering (IPO) or through secured long-term loans from banks. A larger amount might also be financed through selling bonds (debentures), selling Fixed Assets or sale-and-leaseback to rent the assets instead of owning them.
5. Type of the business organization
A well-known and large multinational corporation always finds it much easier to raise finance from a wider range of sources than a sole trader.
A. Unincorporated businesses
A sole trader and partners running a partnership are likely to use their personal finance for setting up and running their businesses. Unincorporated businesses are unable to raise finance by issuing shares.
B. Incorporated businesses
Limited companies, especially public limited companies, have a big advantage over unincorporated businesses when it comes to raising long-term finance. They are able to sell shares to raise money. Share issues can only be used by limited companies. And, only public limited companies can sell shares directly to the public to millions of potential outside investors trading on the stock market. This is largely due to consumers and businesses having confidence in the share issue of world’s largest businesses. If the owners want to retain control of the business at all costs, then a sale of shares might be unwise.
6. Size and status of the business
The business’s size and status may therefore influence the sources of finance available to it.
A. Small businesses
Smaller businesses find it more difficult to borrow from banks and other lenders because they are considered at greater risk of not being able to pay back the amount borrowed. Even when small businesses are able to borrow from banks, they are often charged a higher rate of interest.
B. Large businesses
Large organizations are able to obtain cheap finance (loans with lower interest rates) due to financial economies of scale (borrowing large sums each time), especially as they are able to offer higher levels of collateral than smaller firms.
7. Gearing level
Lenders such as commercial banks always assess the firm’s existing Gearing levels before approving any finance. Gering measures how much of all the capital employed in the business already comes from long-term external borrowing such as long-term bank loans.
The higher the existing debts of a business, comparing with its overall size, the greater the risk for the lender of lending more finance. It is because the business’s interest payments will increase, and the business simply may not have enough Net Profit Before Interest and TAX to pay more interest.
A. Businesses with low Gearing Ratio
Firms with low Gearing are relatively low risk as they do not have many existing debt commitments.
B. Businesses with high Gearing Ratio
Firms with high gearing are relatively high risk as they have existing debt commitments making them more vulnerable to any increase in interest rates which would raise their repayments.
If a business already has existing borrowing, then it might find it more difficult to borrow further amounts. This is because it will be seen as a greater risk.
8. Flexibility
Businesses have variable needs for finance whether they need to make immediate unpredictable payments, or need capital for pre-planned permanent investment projects.
A. Highly flexible sources of finance
Short-term needs that require high flexibility can include seasonal patterns of sales, increasing inventory levels and paying creditors. Flexible sources of finance will include mainly personal funds and reductions in Working Capital. From internal sources of finance, short-term external sources of finance including family and friends, overdraft, trade credit, debt factoring and microfinance. Also, leasing from medium-term external sources of finance.
Example 1: Overdraft might help when the firm needs to suddenly acquire some more raw materials due to higher demand, but it does not have enough money in its current account.
B. Highly inflexible sources of finance
Long-term needs that require low flexibility and injection of permanent capital may be needed for long-term business expansion, or acquiring another business. Inflexible sources of finance include mainly long-term sources such as long-term bank loans and mortgages, bonds, share issue, Venture Capital (VC) and Business Angels. As well as sale of Fixed Assets which come from internal sources of finance.
Example 2: The business should use a bank mortgage when it is thinking of buying another building to use as an office block.
9. External influences
Factors from the external environment have a huge impact on the strategic choice of finance. These external influences are beyond the control of any business.
Social factors. Social factors include demographic influences (aging population, lower birth rates, longer life expectancy, smaller families, rising divorce rates), cultural influences (language, religion, values and beliefs, globalization of cultures) and social influences (women in workforce, flexible working patters, early retirement, people replaced by machines, pressure to act ethically, Virtual Reality (VR) & Augmented Reality (AR), better education) on business activity.
Example 3: With aging population around the world especially in Japan, there is a growing demand to serve senior citizens. Large multinational companies may decide to issue shares to pay for business expansion into the industries such as healthcare and wellness in order to enlarge its product portfolio.
Technological factors. Technological factors include using tools, machines and science in an industrial context. High technology means using advanced machines and robots for industrial actions. Technology is important for creating competitive advantage of the business these days in the globalized world.
Example 4: In order to remain competitive against other businesses, the company may need to lease the newest equipment - faster, more precise and more accurate machines. This will help the business to reduce costs while increasing productivity and improving efficiency.
Economic factors. Economic factors include the state of the economy: economic growth either high or low, inflation caused by excessive aggregate demand and higher costs of production, employment and unemployment, and International Trade Balance (exporting and importing impacted by exchange rates and international trade barriers).
Example 5: When economic growth is low and inflation is high, the state of the economy is not very optimistic. As consumer confidence is low, there will be lower demand for the business’s products. Less supplies will be needed to produce the products therefore the amount of trade credit as a source of finance will be lower.
Environmental factors. Environmental factors including weather conditions and seasonal changes, being environmentally friendly, natural disasters, negative business impact on natural environment (increase in pollution levels, waste creation, overuse of natural resources, use of non-renewable energy sources, destruction of natural environment and emission of greenhouse gasses).
Example 6: In case the company’s premises such as factories and office buildings get seriously damaged as a result of natural disasters, the firm may need to issue bonds (debentures) to pay for rebuilding its facilities.
Political factors. Government influences usually come in the form of politics and regulations. There are two types of government involvements in markets being it either interventionist government or laissez-faire government. Political factors include Fiscal Policy (TAX and government spending), Monetary Policy (interest rates) and Supply Side Policies (privatization, deregulation, domestic policy & foreign policy).
Example 7: Companies will borrow more money when interest rates in the country are low. In the environment with loosen monetary policy, businesses may be willing to take more long-term bank loans to pay for its business growth. Low interest rates tend to stimulate demand leading to new investments.
Legal factors. Legal factors come from laws, rules and regulations that stimulate or constrain business decisions and business activities, try to protect the interests of businesses and ensure that the general public and customers are protected. Legal factors include general labor laws, health and safety laws, marketing behavior laws, consumer rights, business competition legislation, social protection laws and business location legislation.
Example 8: Any company that breaks the law may expect financial punishment by the authorities. If a business does not obey strict health and safety laws, and production workers get seriously injured as a result of this negligence, the business may need to sell Fixed Assets in order to pay for unexpected medical bills or settle expensive lawsuits.
Ethical factors. Ethical factors are mainly related to Corporate Social Responsibility (CSR), the firm’s reputation and brand image, honesty towards stakeholders, fair trade and conducting regular social audits.
Example 9: All businesses that take ethics very seriously and try to maintain high levels of Corporate Social Responsibility (CSR) need to make sure that their annual budgets include available finance for conducting regular social audits and taking time to source ethical suppliers. Most likely, these activities will be paid for using retained profits.
In conclusions, the finance strategy adopted by senior management towards sources of finance has a very significant impact on the future business growth and the overall profitability of the firm. Also, its ability to create and add value using the capital employed. And finally, the control over the business exercised by the existing owners.
It is worth to remember that business failure is largely attributed to the lack of strategic financial planning, proper financial execution and regular financial control.
