Meaning and Nature of Business Finance

Meaning and Nature of Business Finance

• Businesses aim to serve society and earn profit long-term.
• The "going-concern" concept means businesses operate continuously.
• Capital is the initial investment in a business.
• Business finance is the money needed to run a company, crucial for its operations and growth.

Significance of Business Finance

• Purchasing fixed assets like plant, machinery, land, and buildings.
• Smooth daily operations and business expansion.

Financing Needs of the Business

Fixed Capital Requirements

• Funds for purchasing land, buildings, machinery, and furniture.
• Required for a longer period within an organization, the level dependent on the specific company.

Working Capital Requirements

• Funds needed for daily business operations.
• Used for holding current assets (e.g. stock, debtors).
• Amount is influenced by factors like business type and size, and operational cycles.

Classification of Sources of Funds

A. Based on Period

• Short-term: Funds needed for periods of one year or less (trade credit, loans from commercial banks, commercial papers).
• Medium-term: Funds for one to five years (public deposits, lease financing, loans from financial institutions).
• Long-term: Funds for more than five years (shares, debentures, long-term borrowings).

B. Based on Ownership

• Owners' Funds: Capital provided by the business owners (retained earnings, issue of equity shares).
• Borrowed Funds: Funds raised through loans and borrowings (debentures, loans from financial institutions, public deposits, trade credit).

C. Based on Source of Generation

• Internal Sources: Funds generated internally (e.g., retained profits, disposal of surplus inventory).
• External Sources: Funds obtained from external sources (e.g., borrowings from commercial banks, public deposits, issuance of debentures).

Sources of Finance

1. Retained Earnings

• Using profits to reinvest gives a permanent source.
• No explicit costs like dividends/interest.
• Flexible operations and freedom to absorb losses.
• Can raise the market price. Its limitations include potential shareholder dissatisfaction and uncertain profits, potentially resulting in sub-optimal funds allocation.

2. Trade Credit

• Credit extended to businesses by other businesses for goods and services, often without immediate payment.
• Short-term financing tool.
• Terms vary by companies and industries.

3. Factoring

• A 3rd party (factor) collects debts for a business.
• Discounting accounts receivable and/ or collecting payments.
• Improves the company's cash flow.
• Recourse Factoring: The factor doesn't take credit risk, but the business still is potentially liable.
• Non-recourse Factoring: The factor bears the credit risk completely.

4. Lease Financing

• A contract for using an asset.
• The business (lessee) pays for the use of the asset in return (rentals).
• Helps acquire assets via lower investment.
• No dilution of ownership.
• Tax benefits. The company using the leased asset doesn't face the wear and tear risk.

5. Public Deposits

• Money raised from the public directly.
• Relatively high interest rates.
• Funding requirements short- and medium-term.
• An easy and fast source of financing. Requires no security against the business assets.
• Limitations include dependence on the public, especially in large-scale deposits; this can be problematic for smaller companies or in an unstable economic climate.

6. Commercial Papers

• Unsecured promissory notes.
• Used for short-term funding.
• Issued by companies with strong credit ratings.
• Provides higher financing capacity compared to loans. Available quickly and easily.

7. Issue of Shares

• Dividing capital into smaller units—shares—for investors.
• Two main types: equity and preference.
• Equity Shares: Represent ownership in the company, with voting rights and potentially higher returns(fluctuation and variable).
• Preference Shares: Provide a fixed dividend and preference in receiving returns, and no voting rights.

8. Debentures

• A long-term debt instrument, similar to bonds, issued by companies.
• Fixed interest payments, important for long-term projects.
• The issuing company is responsible for repaying the amount, in addition to the interest.

9. Commercial Banks

• Provide various funding options (loans, overdrafts, discounting bills) and services/ support.
• Loans for different time periods.
• Assistance in handling and utilizing the money for day-to-day transactions.

10. Financial Institutions

• Government-supported entities that provide long-term funds.
• Offer managerial advice, financial, and technical support.
• Useful especially in funding expansion. This source can support industries not in business operation alone, but can help promote industrial development in general.

11. International Financing

• Commercial Banks: Provide funding for international operations, often involving currency conversions.
• International Agencies and Development Banks: Offer medium to long-term loans for development in various countries.
• International Capital Markets: Provide funding via instruments like Global Depository Receipts (GDRs) and American Depository Receipts (ADRs).

Factors Affecting the Choice of Source of Funds

• Cost of Finance: Considering the direct and indirect costs.
• Financial Position: The strength and condition of the company in terms of its liquidity and financial risk.
• Form of Business: The business legal structure (sole proprietor, partnership). options are limited by this factor.
• Time Period: Source is selected for short-term or long-term.
• Risk Factors: Risk of the source is compared to return, with lower risk typically preferred.
• Dilution of Control: How much control equity shareholders wish to maintain. This factor influences the selection of debt financing versus equity.
• Creditworthiness: This is a factor affecting the choice of source, where the company credit ratings and history come into focus regarding their ability to take credit/borrow.
• Ease of Issuance: A source easier to secure is desirable.
• Tax Advantages: Tax benefits associated with a particular source are considered as this factor influences financial decisions.