Factors affecting the sources of finance — common mistakes

In case study questions, always identify the specific purpose of the finance (e.g., 'to purchase a new delivery van') and the amount. Use this to justify your choice of finance, explaining why a source is appropriate for that specific purpose and sum.

When analysing a finance choice, explicitly state the expected lifespan of the asset and match it to a source with a similar duration. Explain that this 'matched funding' approach is a sign of prudent financial management and reduces liquidity risk.

When evaluating finance options, always discuss the impact on the gearing ratio. For a business that is already highly geared, you should advise against further debt and explain the associated risks of being unable to meet interest repayments.

For questions involving entrepreneurs or family-owned businesses, a key evaluation point is the trade-off between growth and control. Contrast the impact of a bank loan (retains control) with issuing new shares (loses control) on the original owners' decision-making power.

Do not recommend unrealistic sources of finance. A sole trader cannot have a share issue. A small, loss-making business is unlikely to secure a large debenture. Always ground your recommendations in the context provided in the case study.

Initially, debt can appear cheaper because interest rates are often lower than the expected returns (dividends and capital growth) for shareholders. However, high levels of debt increase financial risk (gearing). If interest rates rise or profits fall, a highly geared business can face insolvency. Furthermore, interest payments are a legal obligation, whereas dividend payments are not. So, while the 'headline' cost may be lower, the overall risk-adjusted cost can be higher.

Not necessarily. The choice is heavily restricted by 'availability'. A small, new business has a very limited menu of options, often relying on owner's capital or small bank loans. A large, established Plc can access a much wider range, including the stock market. The economic climate, the business's credit history, and its current level of debt all act as constraints, meaning the 'best' theoretical option may not be an accessible one.

No, not in the same way as a shareholder. A bank is a lender (a creditor), not an owner. They have no voting rights and cannot dictate business strategy. However, the loan agreement will contain 'covenants' – conditions the business must meet, such as maintaining certain financial ratios. If the business breaches these covenants or fails to make repayments, the bank can take legal action, which may include seizing assets pledged as security (collateral). This is a loss of assets, not a loss of ownership control.