The choice of the source of finance depends upon a number of factors further depending upon the time, purpose, the type of organization etc. All these factors are to be considered before making a choice of source of funds:
Both types of cost i.e. the cost of procurement of funds and cost of utilizing the funds should be taken into account while deciding about the source of funds .
2. Financial strength and stability of operations:
The financial strength i.e. sound financial position to repay the principal amount and interest on the borrowed amount is a major factor for this choice. When the earnings of the organization are not stable, fixed charged funds like preference shares and debentures should be carefully selected as these add to the financial burden of the organization.
3. Form of organization and legal status:
The form of business organization and status affects the choice of a source for raising money, e.g. a partnership firm cannot raise money by issue of equity shares.
4. Purpose and time period:
A short-term need can be met through borrowing funds at low rate of interest through trade credit, commercial paper, etc. whereas for long term finance, sources such as issue of shares and debentures are more appropriate. Similarly, a long-term business expansion plan should not be financed by a bank overdraft which will be required to be repaid in the short term.
5. Risk profile:
Business should evaluate each of the sources of finance on the basis of risk involved. E.g. there is a least risk in equity as compared to a loan that has a repayment schedule for both the principal and the interest. The interest must be paid even if the borrowing company is incurring a loss.
Issue of equity shares means risk of dilution of the control as equity share holders enjoy voting rights. Thus, business firm should choose a source keeping in mind the extent to which they are willing to share their control over business.
7. Effect on credit worthiness:
The dependence of business on certain sources may affect its credit worthiness in the market e.g. issue of secured debentures may affect the interest of unsecured creditors of the company and may adversely affect their willingness to extend further loans as credit to the company.
8. Flexibility and ease:
Restrictive provisions, detailed investigation and documentation in case of borrowings from banks and financial institutions may be the reason that a business organization may not prefer it, if other options are readily available.
9. Tax benefits:
The dividend on preference shares is not tax deductible, interest paid on debentures and loan is tax deductible and may, therefore, be preferred by organizations seeking tax advantage.