Finance represents the money management and the process of acquiring the funds. Business Financing is a board term that describes the activities related to banking, leverage or debt, credit, capital markets, money and investments.
Business finance tells about the funds and credit employed in the business. It also helps to manage the funds/money to make your business more profitable by considering financial statements (profit and loss accounts, balance sheets and cash flow statements).
Financial decisions affect both the profitability and the risk of a firm’s operations. An increase in cash holdings, for instance, reduces risk; but, because cash is not an earning asset, converting other types of assets to cash reduces the firm’s profitability. Similarly, the use of additional debt can raise the profitability of a firm (because it is expanding its business with borrowed money), but more debt means more risk. Striking a balance—between risk and profitability—that will maintain the long-term value of a firm’s securities is the task of finance.
Business finance is the funding a business needs for commercial purposes. It is the money business owners require to start, run or expand a business.
This finance can come from a number of different places. Some of these include:
Investments: Investors may choose to invest capital in a business in the hopes of seeing their investment rise after a set amount of time.
Business Loans: Some business owners prefer to borrow money from a bank for example in the form of a loan and repay over an agreed period of time.
Crowdfunding: There has been a rise of crowdfunding websites such as Kickstarter, Crowdfunder and Patreon. So many businesses are turning to the public as a source of finance.
Grants: A grant is a set amount of money that the government, a company or another organization can award. Grants are advantageous as you do not have to pay the money back. Although they tend to be very difficult to acquire.
According to B.O. Wheeler Meaning of Business Finance includes those business activities that are concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of a business enterprise.”
Business is identified with the generation and circulation of products and services for fulfilling of needs of society. For successfully doing any operation, business requires money which is known as business finance. Therefore, funds are known as the lifeblood of any business. A business would not function unless there is adequate money accessible for use.
The capital contributed by the businessman to establish the business isn’t adequate to meet the financial needs of the business. Consequently, the businessman needs to search for an option to generate funds. A research of the financial needs and options to fulfill those needs must be done with a specific end goal to arrive at effective financial management to maintain the business.
- Fixed Capital Requirement: In order to begin a business, money is required to buy fixed assets like land, building, plant and machinery. This is called the Fixed Capital Requirement.
- Working Capital Requirement: A business needs funds for its day to day activities. This is known as Working Capital Requirements. Working capital is required for the purchase of raw materials, paid salaries, wages, rent, and taxes.
- Diversification: A company needs more funds to diversify its activities to become a multi-product company e.g. ITC.
- Technology upgrading: Finances are needed to adopt the latest technology for example use of particular software and the latest computers in business.
Importance of Business Financing
Capital is the most important tool when it comes to bridging the gap between your production and your sales. Business finance can be used for a number of important purposes. These include:
When dealing with business finance, it’s important to go through your financial statements and connect the dots. This is between your profit and loss as well as your balance sheet and cash flow statements. You can then conclude from your documents if there is a shortage of capital. Business finance can provide the tools to plan strategies for correcting the shortage.
Every business should have a solid strategy in place. This is used for planning and providing the financial groundwork for your projections and plans.
If you are looking to expand your business, you will use business finance to tell you how much you’ll have to spend to get things moving.
These strategic plans help you to determine whether or not your company is meeting it’s long and short-term goals.
It’s not uncommon to run into cash flow difficulties. When this happens, business finance is a vital tool for managing and understanding your financing options.
By incorporating this information into your financial statements, you can make more educated decisions about how much capital to borrow. You can also decide which options make the most sense and your repayment schedule.
It’s all well and good having a great product and business model, but to be a successful business you need people to be aware of you.
The best way to do this is through promotion and marketing. There is a large demand for market research so most of the time this does not come cheap. So it’s important to set aside a section of your fiance to be put towards making sure your product is accessible to your target market.
Business finance is key in any business. If your finances are mishandled or poorly managed then you could run into some serious issues further down the line.
That’s why getting a grip on your business finance is a top priority whose importance should never be underestimated.
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Short-term financial operations
Financial planning and control
Short-term financial operations are closely involved with the financial planning and control activities of a firm. These include financial ratio analysis, profit planning, financial forecasting, and budgeting.
Financial ratio analysis
A firm’s balance sheet contains many items that, taken by themselves, have no clear meaning. Financial ratio analysis is a way of appraising their relative importance. The ratio of current assets to current liabilities, for example, gives the analyst an idea of the extent to which the firm can meet its current obligations. This is known as a liquidity ratio. Financial leverage ratios (such as the debt–asset ratio and debt as a percentage of total capitalization) are used to make judgments about the advantages to be gained from raising funds by the issuance of bonds (debt) rather than stock. Activity ratios, relating to the turnover of such asset categories as inventories, accounts receivable, and fixed assets, show how intensively a firm is employing its assets. A firm’s primary operating objective is to earn a good return on its invested capital, and various profit ratios (profits as a percentage of sales, of assets, or of net worth) show how successfully it is meeting this objective.
Ratio analysis is used to compare a firm’s performance with that of other firms in the same industry or with the performance of industry in general. It is also used to study trends in the firm’s performance over time and thus to anticipate problems before they develop.
Ratio analysis applies to a firm’s current operating posture. But a firm must also plan for future growth. This requires decisions as to the expansion of existing operations and, in manufacturing, to the development of new product lines. A firm must choose between productive processes requiring various degrees of mechanization or automation—that is, various amounts of fixed capital in the form of machinery and equipment. This will increase fixed costs (costs that are relatively constant and do not decrease when the firm is operating at levels below full capacity). The higher the proportion of fixed costs to total costs, the higher must be the level of operation before profits begin, and the more sensitive profits will be to changes in the level of operation.
The financial manager must also make overall forecasts of future capital requirements to ensure that funds will be available to finance new investment programs. The first step in making such a forecast is to obtain an estimate of sales during each year of the planning period. This estimate is worked out jointly by the marketing, production, and finance departments: the marketing manager estimates demand; the production manager estimates capacity; and the financial manager estimates availability of funds to finance new accounts receivable, inventories, and fixed assets.
For the predicted level of sales, the financial manager estimates the funds that will be available from the company’s operations and compares this amount with what will be needed to pay for the new fixed assets (machinery, equipment, etc.). If the growth rate exceeds 10 percent a year, asset requirements are likely to exceed internal sources of funds, so plans must be made to finance them by issuing securities. If, on the other hand, growth is slow, more funds will be generated than are required to support the estimated growth in sales. In this case, the financial manager will consider a number of alternatives, including increasing dividends to stockholders, retiring debt, using excess funds to acquire other firms, or, perhaps, increasing expenditures on research and development.
Once a firm’s general goals for the planning period have been established, the next step is to set up a detailed plan of operation—the budget. A complete budget system encompasses all aspects of the firm’s operations over the planning period. It may even allow for changes in plans as required by factors outside the firm’s control.
Budgeting is a part of the total planning activity of the firm, so it must begin with a statement of the firm’s long-range plan. This plan includes a long-range sales forecast, which requires a determination of the number and types of products to be manufactured in the years encompassed by the long-range plan. Short-term budgets are formulated within the framework of the long-range plan. Normally, there is a budget for every individual product and for every significant activity of the firm.
Establishing budgetary controls requires a realistic understanding of the firm’s activities. For example, a small firm purchases more parts and uses more labour and less machinery; a larger firm will buy raw materials and use machinery to manufacture end items. In consequence, the smaller firm should budget higher parts and labour cost ratios, while the larger firm should budget higher overhead cost ratios and larger investments in fixed assets. If standards are unrealistically high, frustrations and resentment will develop. If standards are unduly lax, costs will be out of control, profits will suffer, and employee morale will drop.
Whereas short-term loans are repaid in a period of weeks or months, intermediate-term loans are scheduled for repayment in 1 to 15 years. Obligations due in 15 or more years are thought of as long-term debt. The major forms of intermediate-term financing include (1) term loans, (2) conditional sales contracts, and (3) lease financing.
A term loan is a business credit with a maturity of more than 1 year but less than 15 years. Usually the term loan is retired by systematic repayments (amortization payments) over its life. It may be secured by a chattel mortgage on equipment, but larger, stronger companies are able to borrow on an unsecured basis. Commercial banks and life insurance companies are the principal suppliers of term loans. The interest cost of term loans varies with the size of the loan and the strength of the borrower.
Term loans involve more risk to the lender than do short-term loans. The lending institution’s funds are tied up for a long period, and during this time the borrower’s situation can change markedly. To protect themselves, lenders often include in the loan agreement stipulations that the borrowing company maintain its current liquidity ratio at a specified level, limit its acquisitions of fixed assets, keep its debt ratio below a stated amount, and in general follow policies that are acceptable to the lending institution.
It is not necessary to purchase assets in order to use them. Railroad and airline companies in the United States, for instance, have acquired much of their equipment by leasing it. Whether leasing is advantageous depends—aside from tax advantages—on the firm’s access to funds. Leasing provides an alternative method of financing. A lease contract, however, being a fixed obligation, is similar to debt and uses some of the firm’s debt-carrying ability. It is generally advantageous for a firm to own its land and buildings, because their value is likely to increase, but the same possibility of appreciation does not apply to equipment.
The statement is frequently made that leasing involves higher interest rates than other forms of financing, but this need not always be true. Much depends on the firm’s standing as a credit risk. Moreover, it is difficult to separate the cash costs of leasing from the other services that may be embodied in a leasing contract. If the leasing company can perform nonfinancial services (such as maintenance of the equipment) at a lower cost than the lessee or someone else could perform them, the effective cost of leasing may be lower than other financing methods.
Although leasing involves fixed charges, it enables a firm to present lower debt-to-asset ratios in its financial statements. Many lenders, in examining financial statements, give less weight to a lease obligation than to a loan obligation.
Long-term financial operations
Long-term capital may be raised either through borrowing or by the issuance of stock. Long-term borrowing is done by selling bonds, which are promissory notes that obligate the firm to pay interest at specific times. Secured bondholders have prior claim on the firm’s assets. If the company goes out of business, the bondholders are entitled to be paid the face value of their holdings plus interest. Stockholders, on the other hand, have no more than a residual claim on the company; they are entitled to a share of the profits, if there are any, but it is the prerogative of the board of directors to decide whether a dividend will be paid and how large it will be.
Long-term financing involves the choice between debt (bonds) and equity (stocks). Each firm chooses its own capital structure, seeking the combination of debt and equity that will minimize the costs of raising capital. As conditions in the capital market vary (for instance, changes in interest rates, the availability of funds, and the relative costs of alternative methods of financing), the firm’s desired capital structure will change correspondingly.
The larger the proportion of debt in the capital structure (leverage), the higher will be the returns to equity. This is because bondholders do not share in the profits. The difficulty with this, of course, is that a high proportion of debt increases a firm’s fixed costs and increases the degree of fluctuation in the returns to equity for any given degree of fluctuation in the level of sales. If used successfully, leverage increases the returns to owners, but it decreases the returns to owners when it is used unsuccessfully. Indeed, if leverage is unsuccessful, the result may be the bankruptcy of the firm.
There are various forms of long-term debt. A mortgage bond is one secured by a lien on fixed assets such as plant and equipment. A debenture is a bond not secured by specific assets but accepted by investors because the firm has a high credit standing or obligates itself to follow policies that ensure a high rate of earnings. A still more junior lien is the subordinated debenture, which is secondary (in terms of ability to reclaim capital in the event of a business liquidation) to all other debentures and specifically to short-term bank loans.
Periods of relatively stable sales and earnings encourage the use of long-term debt. Other conditions that favour the use of long-term debt include large profit margins (they make additional leverage advantageous to the stockholders), an expected increase in profits or price levels, a low debt ratio, a price–earnings ratio that is low in relation to interest rates, and bond indentures that do not impose heavy restrictions on management.
Equity financing is done with common and preferred stock. While both forms of stock represent shares of ownership in a company, preferred stock usually has priority over common stock with respect to earnings and claims on assets in the event of liquidation. Preferred stock is usually cumulative—that is, the omission of dividends in one or more years creates an accumulated claim that must be paid to holders of preferred shares. The dividends on preferred stock are usually fixed at a specific percentage of face value. A company issuing preferred stock gains the advantages of limited dividends and no maturity—that is, the advantages of selling bonds but without the restrictions of bonds. Companies sell preferred stock when they seek more leverage but wish to avoid the fixed charges of debt. The advantages of preferred stock will be reinforced if a company’s debt ratio is already high and if common stock financing is relatively expensive.
If a bond or preferred stock issue was sold when interest rates were higher than at present, it may be profitable to call the old issue and refund it with a new, lower-cost issue. This depends on how the immediate costs and premiums that must be paid compare with the annual savings that can be obtained.
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