What is the primary difference between an overdraft and a bank loan in terms of flexibility?

An overdraft is highly flexible, allowing a business to borrow only what it needs up to a limit and pay interest only on the balance used. A bank loan is a fixed sum with a set repayment schedule and interest charged on the full amount regardless of usage.

How does the 'Matching Principle' apply to the purchase of a new factory?

Since a factory is a long-term non-current asset with a life of 20+ years, it should be funded by long-term finance like a mortgage or share capital. This ensures the business isn't forced to repay the capital before the factory has generated enough profit to cover the cost.

Why is debt often considered 'cheaper' than equity for a profitable company?

Debt is usually cheaper because interest payments are tax-deductible expenses, reducing the overall tax burden. Additionally, lenders take less risk than shareholders (as they are paid first in liquidation), so they demand a lower rate of return.

What is the risk of using a short-term overdraft to fund a long-term expansion project?

The main risk is 'liquidity risk' or 'repayment risk.' Overdrafts are repayable on demand; if the bank cancels the facility before the project generates cash, the business may face insolvency because it cannot quickly liquidate the project to pay the debt.

Define 'Gearing' and its significance in choosing finance.

Gearing is the ratio of long-term debt to total capital employed. High gearing means the business has high fixed interest obligations, making it more vulnerable to interest rate rises or downturns in trading profit.

What is the difference between 'Leasing' and 'Hire Purchase'?

In leasing, the business pays to use an asset but never owns it, which is good for assets that depreciate quickly. In hire purchase, the business pays in installments and gains full ownership of the asset after the final payment.

Why might a startup struggle to obtain a long-term bank loan?

Startups often lack a proven track record of profitability and sufficient 'collateral' (assets to secure the loan). Banks view them as high-risk, making them more likely to rely on equity from owners or venture capitalists.

What is 'Trade Credit' and when is it appropriate?

Trade credit is an agreement where a business buys goods now and pays the supplier later (e.g., in 30-60 days). It is an interest-free short-term source appropriate for managing daily working capital and inventory purchases.

What is a common mistake when evaluating the 'cost' of retained profits?

The common mistake is assuming retained profit is 'free.' While it has no explicit interest, it has an 'opportunity cost' because those funds could have been paid as dividends to shareholders or invested elsewhere to earn a return.

How does 'Venture Capital' differ from a standard 'Bank Loan'?

Venture capital is an equity investment where the investor takes a share of the business and often provides expertise, expecting high returns. A bank loan is debt that must be repaid with interest and does not involve sharing ownership or management.

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Choosing Appropriate Sources of Finance

Summary

Selecting the right financial source is a strategic decision that aligns a business's capital needs with its operational goals, risk appetite, and ownership structure. The process involves evaluating the trade-offs between cost, control, and financial stability, primarily guided by the 'Matching Principle' which dictates that the duration of the finance should correspond to the life of the asset being funded.

1. The Matching Principle

Core Concept: The matching principle suggests that the term of the finance should match the expected life of the asset or the duration of the need. This ensures that the business does not face liquidity crises by having to repay debt before the asset has generated sufficient returns.
Short-term Needs: Current assets like inventory or seasonal fluctuations in trade receivables should be funded by short-term sources such as bank overdrafts or trade credit. Using long-term debt for these needs is inefficient as interest is paid on capital that may sit idle.
Long-term Needs: Non-current assets like machinery, land, or long-term research projects should be funded by long-term sources such as mortgages, debentures, or share capital. This provides the business with the 'permanent' capital required to sustain long-term growth without the pressure of immediate repayment.

Diagram illustrating the Matching Principle: Short-term assets aligned with short-term finance, and long-term assets aligned with long-term finance.

2. Internal vs. External Sources

Internal Sources: These include retained profits and the sale of surplus assets. They are generally considered the 'cheapest' form of finance because they do not incur interest charges or administrative fees associated with issuing new securities.
External Sources: These involve obtaining funds from outside the business, such as bank loans, leasing, or issuing new shares. While they provide access to larger sums of capital, they often come with costs like interest, dividends, and potential loss of control.
Strategic Choice: A business will typically exhaust internal sources first to maintain financial independence before seeking external capital, a concept known as the 'Pecking Order Theory'.

3. Debt vs. Equity Financing

4. Qualitative Factors in Selection

5. Exam Strategy & Tips