Financing of Business and Financial Statements

Financing of Business

• Financing is the lifeblood of any business, encompassing the methods and means to secure funds for starting, running, and expanding operations.
• Understanding the basis of business finance, need for finance, kinds of capital, and sources of both fixed and working capital is crucial for entrepreneurs and business managers.

Basis of Business Finance

• Business finance refers to the funds required for establishing, operating, and expanding a business.
• It involves understanding the financial needs of a business, planning for those needs, and managing funds efficiently to achieve business objectives.
• Key elements of business finance include:
  • Capital Structure: mix of debt and equity to finance operations.
  • Financial Planning: ensuring the right amount of funds at the right time.
  • Investment Decisions: allocating funds to assets or projects.
  • Funding Decisions: deciding on sources of funds and terms of financing.

Need for Finance

• The need for finance arises at various stages of a business lifecycle, including:
  • Starting a business: initial funding for business formation and capital expenditures.
  • Operating expenses: day-to-day operational costs, such as salaries and raw materials.
  • Expansion and growth: additional funds for expanding operations, entering new markets, or launching new products.
  • Research and development: investment in innovation and product development.
  • Risk management: maintaining reserves to manage unforeseen risks and uncertainties.

Kinds of Capital

• Capital is classified into two main types:
  • Fixed capital: long-term assets used over a long period, such as land, buildings, and machinery.
  • Working capital: short-term capital used for day-to-day operations, calculated as the difference between current assets and current liabilities.

Sources of Fixed Capital

• Fixed capital is typically sourced from:
  • Equity financing: raising capital by selling shares of the company.
  • Debt financing: borrowing funds from external sources, such as banks or bondholders.
  • Retained earnings: profits retained in the business after distributing dividends.
  • Leasing: acquiring the use of long-term assets without purchasing them outright.
  • Venture capital: private equity provided to startups and small businesses with high growth potential.

Sources of Working Capital

• Working capital is sourced from:
  • Trade credit: purchasing goods and services on credit.
  • Bank overdraft: facility provided by banks to withdraw more money than available in the account.
  • Short-term loans: borrowing funds from banks or financial institutions.
  • Commercial paper: short-term debt instrument issued by large companies to raise funds.
  • Factoring: selling accounts receivable to a third party.
  • Inventory financing: using inventory as collateral to secure short-term loans.
  • Internal accruals: funds generated from business operations, such as profits and depreciation.

Financial Statements

• Financial statements are crucial tools that provide insights into a company's financial health.
• The two primary financial statements are:
  • Profit and Loss Statement (Income Statement): summarizes revenues, costs, and expenses incurred during a specific period.
  • Balance Sheet (Statement of Financial Position): provides a snapshot of a company's financial condition at a specific point in time.

Profit and Loss Statement

• The Profit and Loss Statement includes:
  • Revenue: total amount of money earned from the sale of goods or services.
  • Cost of Goods Sold (COGS): direct cost attributable to the production of goods sold.
  • Gross Profit: calculated by subtracting COGS from revenue.
  • Operating Expenses: costs required to run the day-to-day operations of the business.
  • Operating Income: calculated by subtracting operating expenses from gross profit.
  • Non-Operating Income and Expenses: income and expenses not related to the core business operations.
  • Earnings Before Tax (EBT): calculated by adding non-operating income and subtracting non-operating expenses from operating income.
  • Taxes: amount of tax expense incurred by the company during the period.
  • Net Income: calculated by subtracting taxes from EBT.

Balance Sheet

• The Balance Sheet includes:
  • Assets: resources owned by the company that have economic value and can provide future benefits.
  • Liabilities: obligations the company owes to outside parties.
  • Shareholders' Equity: owners' claim on the assets of the company after all liabilities have been deducted.

Depreciation Analysis

• Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life.
• Causes of depreciation include:
  • Wear and tear: physical deterioration of assets.
  • Obsolescence: technological advancements and changes in market preferences.
  • Usage: extent and intensity of an asset's usage.
  • Passage of time: certain assets depreciate due to the passage of time.
  • Depletion: natural resources deplete over time.

Significance of Depreciation

• Depreciation plays a vital role in financial management and accounting for:
  • Accurate profit measurement.
  • True value representation of assets.
  • Tax implications.
  • Investment decisions.
  • Budgeting and forecasting.

Methods of Calculating Depreciation

• Several methods can be used to calculate depreciation, including:
  • Straight-Line Method: allocates an equal amount of depreciation expense each year.
  • Declining Balance Method: applies a constant depreciation rate to the book value of the asset.
  • Units of Production Method: ties depreciation expense directly to the asset's usage.
  • Sum-of-the-Years'-Digits Method: an accelerated depreciation method that applies a decreasing fraction of the depreciable base to each year.