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