3.2.3 Internal vs. external sources and implications Notes

Choosing the Most Suitable Source of Finance

1. No single source of finance fits all circumstances.
2. Businesses need to evaluate various factors to determine which source or combination of sources is best suited to their needs.
3. Below are the key considerations for selecting the appropriate source of finance:

1. Expected Timescales

1. Short-term finance is used to cover immediate needs, such as paying bills or funding operating expenses.
2. Consider sources like overdrafts and trade credit, typically required for revenue expenditure lasting less than a year.
3. Long-term finance is needed for significant investments like purchasing property or vehicles.
4. Consider sources like loan capital or share capital, which fund capital expenditure that spans many years.

2. The Firm's Legal Structure

1. A business’s legal form directly affects its access to finance.
2. Sole traders and partnerships often rely on personal funds, overdrafts, or microfinance, as they are perceived as riskier by external investors and may lack internal funds.
3. Private limited companies can use shareholder investments, loan capital, or venture capital, but must consider shareholder approval for share issues.
4. Public companies benefit from raising funds via stock exchanges through public share issues or rights issues.

3. The Cost of the Source of Finance

1. Cost is a critical factor for selecting finance:
   1. Interest rates: High interest rates increase borrowing costs, especially for riskier businesses.
   2. Costs of selling shares: Public share issues are expensive, involving fees for merchant banks and promotion.
   3. Opportunity cost: Using retained profits means forgoing reinvestment opportunities

4. Retention of Control

1. Some sources of finance, like issuing shares, may dilute control.
2. Private/public companies issuing voting shares risk losing decision-making power to new shareholders.
3. Businesses can issue non-voting shares to retain control, though these are less attractive to investors.
4. Business angels or venture capitalists may demand decision-making rights, which can affect independence.

5. How The Money Will Be Used

1. Different needs require specific sources:
   1. A mortgage is ideal for long-term property investments, as it offers large capital at relatively low interest rates.
   2. A business angel may be more suitable for risky startups, as they provide expertise alongside funding.

6. Existing Debt

1. Businesses with high debt levels may struggle to access additional finance.
   1. Banks are hesitant to lend if debt exceeds 50% of total capital.
   2. Alternative options like selling assets or issuing shares may be necessary.

Summarizing The Sources of Finance and Their Suitability Different Business Entities

Summarizing The Sources of Finance and Their Time Frames