Factors Influencing Financing Decision For a Firm, and Different Types of Finance Available For a Firm

Bandyopadhyay and Nandita (2016) explain that there are external and internal factors that influence financing decisions. External factors are factors beyond control of a firm’s management and encompass environmental factors surrounding a firm. Comparatively, internal factors refer to factors related with a company’s internal conditions such as nature of its business and its size (Umair, 2015). Based on this background, factors influencing financing decision will be addressed.

Firstly, Bartram et al. (2015) contend that before a firm makes a financing decision, it should take into account the needs of potential investors since different investors have different profitability and other liquidity demands. As such, liquidity conscious investors would for example like to hold enough securities in order to feel that their investments are secure. Conversely, other investors may not be so conservative and may be willing to take more risk and would want to invest savings in equities. Consequently, a firm requiring to raise huge amount of funds in this scenario has to issue various types of securities to cater more of its investors.

Secondly, financial institutions’ lending policy often influence a firm’s financing decision (Darmodaran, 2015). For example, if these institutions prefer certain projects that their assessment would indicate are less risky, and as such provide finance to them, a firm may be inclined to prefer the same projects even if its assessment contradicts that of financial institutions, if other factors remain equal. Thirdly, Brealey et al. (2017) concede that the nature of a business play a vital role in influencing its financing decision. For instance, a manufacturing firm spends most of its funds acquiring fixed assets, whereas a trading company utilises most of its funds in current assets. Consequently, a manufacturing firm may prefer dividend policy offering high dividend rate, whereas a firm trading in luxury products would prefer a policy emphasising on higher earnings retention (Bodmer, 2014).

Fourthly, companies operating in the same industry may have different financing patterns due to their different sizes. This is because huge amount of financing is needed for fixed assets which may be afforded by large firms, while smaller firms may opt to lease (Balios et al., 2016). Similarly, smaller firms with limited finance may lease or rent building and equipment to undertake their operations, while large firms often build their facilities and buy equipment.

Furthermore, Darmodaran (2015) postulates that there are two sources of finance based on their source of generation. These are internal and external sources. The former refers to finance generated within the business as it undertakes its operations. These include retained earnings and sale of fixed assets. Conversely, external sources refer to finance provided by financial institutions and investors which on basis of its nature it can be categorised as equity financing and debt financing (see figure 1 below).

Figure 1: External sources of finance

Source: Author

Additionally, internal and external sources of finance have their different purpose. For example, internal sources are mostly used to finance daily business operations, but for firms making huge profits they can use them to expand their businesses. Comparatively, external sources are most of the time used to start a business or later to expand it when internally generated funds are not enough. Further, firms making losses may use them for their daily activities (Pandey, 2015).