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Factors Affecting the Choice of the Source of Funds

Last Updated : 06 Apr, 2023
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Every organization requires capital to run its daily operations. The initial capital of a firm can never be sufficient for the proper running of the business. Therefore, it has to identify and estimate the financial needs and different sources from where funds can be arranged. A business can run its operations effectively and efficiently if it has adequate funds and makes the best use of them. 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 limitations, companies usually use a combination of sources rather than relying on a single source. Different factors that affect the choice of the source of funds are as follows:

1. Cost

When an organization acquires funds it has to incur some costs. Cost is a major element, as it directly affects an enterprise. Therefore, the cost of procurement of funds, as well as the cost of utilizing the funds are taken into consideration while deciding the choice of funds, that will be used by an organization. 

2. Financial Strength and Stability of Operations

A company’s financial strength and position are key elements to be taken into account while deciding the source of funds. Funds need to be repaid to the source from where 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 shares and debentures should not be taken.

3. Form of Organization and Legal Status

The legal status (i.e., sole proprietorship, partnership or company) of a business allows or prohibits choosing from various options of funds. Therefore, an organization has to take its legal status and form into consideration while choosing the source of funds. For example, only a public company can issue equity shares to raise money from the market, not a partnership business or even a private company. 

4. Purpose and Period

The purpose and period are important factors that affect the choice of source of funds. Every organization has its financial needs for different purposes. Some need the funds for capital expansion, some for their survival, etc. Therefore, a firm has to properly define its purpose of financial needs for the selection of the source. Besides, the number of sources from which an organization can choose funds for the short term is more than the number of sources available from which an organization can choose funds for the long term. Therefore, the time period also plays a major role in deciding the source of funds. 

5. Risk Profile

Every source of funds involves some kind of risk. The risk factor associated with a different type of source of finance varies from each other. For example, there is the least risk in equity 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 debentures are the opposite in terms of payment of interest.

6. Control

Some sources of funds require sacrificing the firm’s control over the business, while some of them do not involve sacrificing control. Therefore, a company has to decide whether or not it wants to sacrifice its control over the company before choosing the perfect source of funds. For example, 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 does not have to compromise with ownership and control.

7. Effect on Credit Worthiness

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

8. Flexibility and Ease

Flexibility and ease of a source of funds play a crucial role in its selection. Generally, an organization prefers options which are more flexible and easy rather than those which have restrictive provisions, detailed investigation and documentation.

9. Tax Benefits

Various sources offer different tax benefits to the organization. The dividend on preference shares is not deductible from the taxable income, but the interest paid on debentures and loans is tax-deductible.

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