Evaluating and Recommending Sources of Finance
Framework for Choosing a Source of Finance
When advising on or evaluating a source of finance, consider:
- Size of sum required — large sums suit debentures or share issue; small sums suit overdraft or loan
- Purpose — match the source to the need (matching principle: long-term assets = long-term finance)
- Gearing / attitude to risk — debt finance increases gearing and the fixed interest burden; highly geared businesses are more financially risky
- Control — share issues dilute ownership; debt finance does not
- Cost — interest rates (fixed vs variable), arrangement fees, dividend obligations
- Security — some sources require collateral (loans, mortgages, debentures)
- Impact on liquidity — will repayments or interest create cash flow problems?
- Impact on profitability — interest is an expense (reduces profit); dividends are not
Ordinary Shares vs Debentures
| Basis | Ordinary Shares | Debentures |
|---|
| Control | Dilution of ownership (voting rights) | No change in control |
| Cost | Variable dividends (only paid if profitable) | Fixed interest (must always be paid) |
| Gearing | Reduces gearing | Increases gearing |
| Risk | Lower financial risk | Higher financial risk |
| Profitability | Dividends do not reduce profit for the year | Interest reduces profit every year |
| Repayment | Permanent — no repayment needed | Redeemed at maturity date |
Impact of Share Issue on Liquidity and Profitability
Liquidity:
- Short run: improves liquidity (cash raised)
- Long run: dividends paid to shareholders reduce cash each year (but dividends can be varied or withheld)
- No fixed repayment obligation — no drain on cash flow from capital repayment
Profitability:
- Issuing shares does not affect profit for the year
- Dividends are not deducted in calculating profit (they are an appropriation of profit)
Impact of Debenture Issue on Liquidity and Profitability
Liquidity:
- Short run: improves liquidity (cash raised)
- Long run: fixed interest payments reduce cash each year
- Capital must be repaid in full at maturity — requires planning
Profitability:
- Interest is charged as an expense in the income statement — reduces profit every year
- This charge is fixed regardless of how well or poorly the business performs
Gearing
Gearing measures the relationship between debt finance (non-current liabilities) and equity (share capital + reserves).
- High gearing = high proportion of debt → more financial risk (fixed interest must always be paid)
- Low gearing = mainly equity-financed → lower financial risk
- Issuing ordinary shares reduces gearing
- Taking out loans or debentures increases gearing