Match the funding to two things: what the money is for, and how long it is needed. Short needs suit short-term sources, and assets that earn for years suit long-term sources.
This lesson is part of business finance. The source labels come from comparing internal and external funding.
What is the purpose and duration test?
Ask two questions about the money. The answers point you to the right group of sources.
- Purpose: is it for running costs, such as stock, or for an asset, such as a machine?
- Duration: will the business need it for a few months, or for years?
Running costs over a few months suit short-term sources. An asset that earns over years suits long-term sources.
Worked example: a mismatch
An invented shop, Kedai Roti Jaya, buys an oven for RM12 000. The oven will add RM300 each month to profit for five years. The owner takes a 12-month loan for the full amount.
To keep the numbers simple, ignore interest. Monthly repayment: RM12 000 ÷ 12 = RM1 000. The oven adds only RM300 each month, so each month the shop is short by RM1 000 − RM300 = RM700.
Over the year, the shortfall is 12 × RM700 = RM8 400. The oven has not finished paying for itself, but the loan has ended.
Now match the choice properly. A 60-month term loan spreads repayment: RM12 000 ÷ 60 = RM200 each month, which is below the RM300 the oven earns. The shop stays ahead each month.
The mistake of choosing by amount alone
The common slip is to pick a source because it is large enough. “The loan covers RM12 000, so it is suitable.”
This answers only the amount. Rewrite using purpose and duration: “The oven is a long-lasting asset, so a longer-term loan suits it, because repayments of RM200 each month are covered by the RM300 it earns.”
Check yourself
The shop also needs RM2 000 of flour for the next two months, to be paid from sales. Which type of finance suits this, and why?
Answer
Short-term finance, such as supplier credit, suits it. The purpose is running costs, and the need lasts two months, so the repayment can come from sales soon after.
A five-year loan would be a mismatch: the shop would pay interest for years on a need that ends in two months.
What to study next
Next, check whether the business can afford the repayments. Continue with interpreting cash-flow forecasts, then test yourself in the practice set.
The business case answer planner helps you state purpose, duration and source in order. For a teacher to check your matching, see online one-to-one Business tuition.