Choosing the Right Source of Finance for a Business Scenario
Choosing the right source of finance means matching a business's specific situation to the source that best fits it, rather than simply listing sources and their advantages in the abstract.
Method
- Read the scenario for the amount of finance needed, how urgently it is needed, and what it is for.
- Decide whether the need is short-term, e.g. covering a temporary gap in cash flow, or long-term, e.g. buying a fixed asset or expanding.
- Check the business's legal structure, since this rules some sources in or out, e.g. only a limited company can sell shares.
- Compare the likely cost, e.g. interest rate, and risk, e.g. whether the business has to offer security, or repay regardless of performance, of the realistic options.
- Consider whether the business owner is willing to give up some ownership or control, e.g. taking on a partner or issuing shares, to avoid taking on debt.
- State a clear recommendation, naming one specific source, and justify it using at least two factors from the scenario, rather than just describing the source in general.
Worked example
Tomasz runs a limited company making furniture. He has a large, one-off order and needs 25,000 pounds to buy materials, which he will fully repay within 3 months once the customer pays him. Recommend a suitable source of finance for Tomasz, and justify your recommendation using details from the scenario.
- Identify the amount and purpose: 25,000 pounds, needed for a short period (3 months) to cover materials for a single order.
- Identify that this is a short-term need, since it will be repaid quickly once the customer pays, ruling out sources meant for long-term investment such as a mortgage or share capital.
- Consider suitable short-term sources: an overdraft fits, since it can be drawn down and repaid flexibly as needed, and only used, and charged interest, for the 3 months it takes.
- State the recommendation: an overdraft, justified because the need is short-term and temporary (3 months), the amount can be repaid quickly once the customer pays, and an overdraft avoids the longer-term commitment and higher total interest of a bank loan taken for a need that will not last.
Practice questions
Try each question, then tap to reveal the answer.
Q1State two factors a business owner should consider when choosing a source of finance.Show answer
Answer: For example, how much finance is needed and whether the need is short-term or long-term. Other valid factors include cost, speed, legal structure of the business, and how much control the owner is willing to give up.
Q2A sole trader needs finance but does not want to give up any control of her business. Which source should she avoid, and why?Show answer
Answer: She should avoid share capital, or taking on a business partner, because these sources mean sharing ownership, profits, or decision-making control with someone else.
Q3Why might a business choose an overdraft rather than a bank loan for a short-term cash-flow gap?Show answer
Answer: An overdraft is flexible and is only used, and charged interest, for as long as it is needed, whereas a bank loan is usually a fixed amount borrowed for a set, often longer, term.
Q4Why can a sole trader not raise finance through share capital?Show answer
Answer: Share capital involves selling shares in a limited company, and a sole trader's business is not set up as a company with shares to issue.
Q5A start-up needs 200,000 pounds to buy premises it will use for the next 20 years. Is this a short-term or a long-term finance need? Explain.Show answer
Answer: Long-term, because the premises will be used for many years, so the finance should be repaid or held over a similarly long period, e.g. through a long-term mortgage or share capital, not a short-term source such as an overdraft.
Q6Give one reason a business might prefer leasing equipment rather than buying it outright with a loan.Show answer
Answer: Leasing avoids a large upfront cost, spreads payments over time, and the leasing company is often responsible for maintaining or replacing the equipment.
Q7Why might a lender be unwilling to give a large, unsecured loan to a brand-new business with no trading history?Show answer
Answer: Because the lender has no evidence the business can generate enough income to repay the loan, making it a higher risk; the lender may ask for security, an asset as collateral, or refuse the loan.
Exam-style questions
Written in the style of a GCSE Business exam paper, with a full mark scheme.
A cafe owner needs 10,000 pounds and is choosing between two options to raise it within one year: Option A, a bank loan at a simple interest rate of 7% per year; Option B, an overdraft that she expects to need for only 4 months of the year, at a simple interest rate of 15% per year, charged only for the months it is used. (a) Calculate the interest cost of Option A for the full year. (2 marks) (b) Calculate the interest cost of Option B, given it is used for 4 out of 12 months. (2 marks) (c) State which option costs less in interest, and by how much. (2 marks)
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A sole trader who owns a small clothes shop wants to raise 40,000 pounds to open a second shop in a nearby town. She is choosing between a long-term bank loan and finding an investor who would become a business partner in exchange for a share of future profits. Evaluate which source of finance is more suitable for her situation.
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See real GCSE Business past-paper questions, with official mark schemes →
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