Factors Affecting the Choice of the Source of Funds

Different types of businesses have different types of financial needs. Therefore, business firms resort to different types of sources of funds. As no source of funds is free from risk and certain limitations, companies opt to use a combination of sources rather than relying on a single source. Several factors affect the choice of this combination, we will see them one by one:

1. Cost: The cost of procurement of funds as well as the cost of utilising the funds are taken into consideration while deciding about the choice of funds that will be used by an organisation.

2. Financial Strength and Stability of Operations: Company’s financial strength and position is key element to take into account. Funds need to be repaid to the source it has been generated from, so for this, a business should be financially stable. When the earning position of the business is not stable, fixed charged funds like preference share and debentures shouldn’t be taken.

3. Form of Organisation and Legal Status: The legal entity (i.e. sole proprietorship, partnership or company) of a business allows or prohibits to choose from various options of funds. Like only a public company can issue equity shares to raise money from the market, not the partnership business or even private company. 

4. Purpose & Period: The purpose and period are important factors that affect the choice. Short-term use of funds has different sources where a company can choose from whereas Long-term use of funds has different sources.

5. Risk Profile:  The risk factor associated with a different type of source of finance varies from each other. For example, there is the least risk inequity as the share capital has to be repaid only at the time of winding up and dividends need not be paid if there is no profit but in debentures are opposite in terms of payment of interest.

6. Control: If a company want to generate fund from issuing equity shares then it has to sacrifice a bit of ownership and control to the public whereas by issuing debt funds like debentures or taking a loan, a company doesn’t have to compromise with the ownership and control.

7. Effect on Credit Worthiness: Credit Worthiness is the company’s power or ability to repay the debts. Some source of funds affects the creditworthiness of a company negatively, a company may choose not to consider those options while selecting the source of finance.

8. Flexibility and Ease: Generally, those options which are more flexible and easy are preferable rather than those which have restrictive provisions, detailed investigation and documentation.

9. Tax Benefits: Various sources offer different tax benefits to the organisation, while the dividend on preference shares is not deductible, interest paid on debentures and loan is tax-deductible.