Factors affecting the sources of finance

Gearing is the proportion of a business's finance that comes from debt (borrowing) rather than equity (1); a highly geared business relies heavily on borrowing and so carries more financial risk (1).

One factor is the need to retain control (1). If the owners want to keep full ownership and decision-making power, they should avoid selling shares, because new shareholders would own part of the business, vote, and share in profits, diluting the founders' control (1). They might instead choose a loan or retained earnings, which do not affect ownership — though a loan adds interest and repayment commitments (1).

The first factor is the need to retain control. A share issue brings in new shareholders who own part of the company and can vote, diluting the existing owners' control, whereas a bank loan keeps ownership with the current owners because the lender is only a creditor. A company whose owners value control would lean toward the loan.

The second factor is cost and existing debt. A loan costs interest and must be repaid, and if the company is already heavily borrowed, lenders may refuse it or charge a high rate, making debt risky. A share issue carries no interest and no repayment, which protects cash flow, although it costs a permanent share of future profit.

So the choice depends on weighing the owners' wish for control against the cost and risk of taking on more debt.

The use of finance — what it funds and for how long — is central to the choice because the source should match both the purpose and the time period of the need.

For a long-term need such as buying a factory or expanding, the business should use long-term finance like a mortgage, long-term loan or share capital. These are repaid over many years, matching the time the asset takes to generate returns. Using a short-term source here would be dangerous: an overdraft is repayable on demand, so the bank could recall it before the factory pays off, and the factory cannot be sold quickly to repay — risking a cash crisis.

For a short-term need such as a temporary cash-flow gap, the business should use short-term finance like an overdraft or trade credit. Using a long-term source here would be wasteful: taking a 20-year loan to cover a few weeks' shortage means paying interest for decades on a need that lasts only weeks.

Matching the source to the use therefore protects cash flow and avoids unnecessary cost. The purpose also shapes the source in other ways — buying a vehicle suits leasing or hire purchase, while funding a risky start-up suits venture capital or crowd funding.

Therefore the use is an important factor because mismatching the source and the need can either threaten the firm's survival (long need, short source) or waste money (short need, long source).

Cost is clearly an important factor. The interest and fees on borrowing directly affect profit, and a source that is too expensive can make a project unaffordable. Cheaper finance — such as retained earnings or a low-interest loan — leaves more profit and reduces financial risk, so a cost-conscious business will favour it. For a firm with tight margins, cost may indeed be decisive.

However, other factors can matter more. The use and time period is arguably more fundamental: even cheap finance is wrong if it does not match the need — funding a factory on a cheap overdraft still risks a cash crisis. The need to retain control can override cost: an owner may accept a costlier loan rather than sell shares and lose control. The level of existing debt can be decisive too: a heavily geared firm may be unable to borrow at any cost, forcing it toward equity regardless of price. And flexibility can outweigh cost for a firm with fluctuating needs, which may prefer a higher-rate overdraft to a cheaper but rigid loan.

Judgement. Whether cost is most important depends on the firm's circumstances. For a profitable firm with low debt and a clear purpose, cost may well be the deciding factor. But where keeping control matters greatly, where existing debt blocks borrowing, or where the source must match an unusual time period, those factors outweigh cost. On balance, cost is one of the most important factors but rarely the single most important in every case — the deciding factor is the one that best fits the firm's specific situation, judged against its purpose, debt position and the owners' priorities.

When choosing a source of finance, a business weighs cost, flexibility, the need to retain control, the use of the finance, and its existing debt. The need to retain control is sometimes the dominant concern, but whether it should be the main factor depends on the business and its owners.

The case that control should be the main factor. For many owners, keeping ownership and decision-making power is the whole point of the business. Selling shares brings in new owners who vote, share profit, and can dilute the founders' control — and for a plc this can even lead to a hostile takeover. An entrepreneur who has built a business and wants to keep their vision intact may rightly treat control as the overriding factor, choosing loans, retained earnings or leasing over equity even if these cost more. Where independence is central to the owners' objectives, protecting control can be the most important consideration.

The case that other factors should dominate. First, the use and time period is more fundamental to the firm's survival: a source that does not match the need (a factory funded by an overdraft) endangers cash flow regardless of control. Second, cost can be decisive: very expensive finance can make a project unviable, so a firm with tight margins must prioritise cost. Third, the level of existing debt can remove the choice entirely — a highly geared firm may be unable to borrow, so it has to accept equity and the loss of control whether it likes it or not. Fourth, flexibility matters most for firms with fluctuating needs. In all these cases, control is secondary to the practical realities of getting the right finance at all.

Weighing it up (criterion). Whether control should be the main factor depends on how strongly the owners value independence relative to the firm's financial constraints and the suitability of the finance for its purpose. For an owner-managed firm whose objective is independence and that can fund itself by debt or internal sources, control should indeed be the main factor. For a firm whose survival or growth depends on raising the right finance — where existing debt, cost or matching the purpose constrain the options — those factors must come first, even at the cost of some control.

Judgement. The need to retain control should be the main factor only when the owners genuinely prize independence and the firm has the option to fund itself without giving up control. Where finance is constrained by existing debt, cost, or the need to match a source to its purpose, those factors should dominate, because they determine whether the business can obtain suitable finance at all. So control is the main factor in some situations but not as a general rule; the most defensible position is that the main factor is whichever one most threatens the firm's ability to meet its objective in its specific situation — for some firms that is control, for others it is cost, purpose or existing debt.