INTRODUCTION TO BUSINESS FINANCE

When you start up in business you will need finance. Should you use your own
money, borrow from family and friends, or go straight to the bank? What about
invoice financing and factoring? Do you want a business angel? Understand the
different forms of borrowing and choose the best financial option for your
business.
DEFINITION OF BUSINESS FINANCE
Raising and managing of funds by business organizations. Such activities are
usually the concern of senior managers, who must use financial forecasting to
develop a long-term plan for the firm. Shorter-term budgets are then devised to
meet the plan's goals. When a company plans to expand, it may rely on cash
reserves, expected increases in sales, or bank loans and trade credits extended by
suppliers. Managers may also decide to raise long-term capital in the form of
either debt (bonds) orequity (stock). The value of the company's stock is a constant
concern, and managers must decide whether to reinvest profits or to pay dividends.
Other duties of financial managers include managing accounts and fixing the
optimum level of inventories. When deciding how to deploy corporate assets to
increase growth, financial managers must also consider the benefits of mergers and
acquisitions, analyzing economies of scale and the ability of businesses to
complement each other.

CONCEPT OF BUSINESS FINANCE

Business finance is the area of finance dealing with the sources of funding and
the capital structure of Business and the actions that managers take to increase the
value of the firm to the shareholders, as well as the tools and analysis used to
allocate financial resources. Although it is in principle different from managerial
finance which studies the financial management of all firms, rather than Business
alone, the main concepts in the study of Business finance are applicable to the
financial problems of all kinds of firms. Business finance generally involves
balancing risk and profitability, while attempting to maximize an entity's wealth
and the value of itsstock, and generically entails three primary areas of capital
resource allocation. In the first, "capital budgeting", management must choose
which "projects" (if any) to undertake. The discipline of capital budgeting may
employ standard business valuation techniques or even extend to real options
valuation; see Financial modeling. The second, "sources of capital" relates to how
these investments are to be funded: investment capital can be provided through
different sources, such as by shareholders, in the form of equity (privately or via
an initial public offering), creditors, often in the form of bonds, and the firm's
operations (cash flow). Short-term funding or working capitalis mostly provided by
banks extending a line of credit. The balance between these elements forms the
company's capital structure. The third, "the dividend policy", requires management
to determine whether any unappropriated profit (excess cash) is to be retained for
future investment / operational requirements, or instead to be distributed to
shareholders, and if so in what form. Short term financial management is often
termed

"working

capital

and debtors management.

management",

and

relates

to cash-, inventory-

FINANCIAL MANAGEMENT
Financial management overlaps with the financial function of the Accounting
profession. However, financial accounting is the reporting of historical financial
information, while financial management is concerned with the allocation of
capital resources to increase a firm's value to the shareholders.
Financial risk management, an element of corporate finance, is the practice of
creating and protecting economic value in a firm by usingfinancial instruments to
manage exposure to risk, particularly credit risk and market risk. (Other risk types
include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc.)
It focuses on when and how to hedge using financial instruments; in this sense it
overlaps with financial engineering. Similar to general risk management, financial
risk management requires identifying its sources, measuring it (see: Risk measure:
Well known risk measures), and formulating plans to address these, and can be
qualitative and quantitative. In the banking sector worldwide, the Basel
Accords are generally adopted by internationally active banks for tracking,
reporting and exposing operational, credit and market risks

HOW MUCH DO YOU NEED?

To work this out you need a business plan. The business plan will help you work
out your financial needs, including the initial start up costs and running expense.
You can draw up a budget that shows your forecast sales, expenditure and
absolutely vital your cash position for each month.
Consider possible peaks and troughs in the business (perhaps seasonal) and
remember that many start-ups spend more than they earn in the first couple of
years. Customers may not pay you immediately but you still have to pay all your
bills to keep trading. Make sure you have a contingency fund in case things go
wrong. Try to have at least enough capital to cover projected expenses for at least
six months the nature of your particular business may mean you need more.

HOW THE CHOICE OF FINANCE IS MADE IN A BUSINESS

These are the factors that managers consider when choosing the type of finance
they need.
Purpose And Time Period: Managers need to match the source of finance to
its purpose. It is quite simple, short-term finance is used to buy current assets
and things like that, while long-term finance for fixed assets and similar things.
Amount Needed: Different types of finance depends on how much is needed.
Status And Size: Bigger companies have more choices of finance. They pay
less interest to banks.
Control: owners lose control if they own less than 51% of shares in their
company.
Risk And Gearing: loans raise the gearing of a business, meaning that their
risk is increased. Gearing is can be obtained by calculating the percentage of
long-term loans compared to total capital. If long-term loans take up more than
50% of total capital, then the business would be called highly geared. This is
very risky because the business will have to pay back a lot of its loans and has
to succeed to do so. Banks are less willing to lend to these businesses, so they
will have to find other types of finance.

FINANCIAL ECONOMICS

Financial economics is the branch of economics studying the interrelation of

financial variables, such as prices, interest rates and shares, as opposed to those
concerning the real economy. Financial economics concentrates on influences
of real economic variables on financial ones, in contrast to pure finance. It centres
on

managing

risk

in

the

context

of

the financial

markets,

and

the

resultanteconomic and financial models. It essentially explores how rational

investors would apply risk and return to the problem of aninvestment policy. Here,
the twin assumptions of rationality and market efficiency lead to modern portfolio
theory (the CAPM), and to the BlackScholes theory for option valuation; it
further studies phenomena and models where these assumptions do not hold, or are
extended. "Financial economics", at least formally, also considers investment under
"certainty" (Fisher separation theorem, "theory of investment value", ModiglianiMiller theorem) and hence also contributes to corporate finance theory. Financial
econometrics is the branch of financial economics that uses econometric
techniques to parameterize the relationships suggested.
Although closely related, the disciplines of economics and finance are distinctive.
The economy is a social institution that organizes a societys production,
distribution, and consumption of goods and services, all of which must be
financed.
Economists make a number of abstract assumptions for purposes of their analyses
and predictions. They generally regard financial markets that function for the
financial system as an efficient mechanism (Efficient-market hypothesis). Instead,
financial markets are subject to human error and emotion.[3] New research discloses
the mischaracterization of investment safety and measures of financial products
and markets so complex that their effects, especially under conditions of
uncertainty, are impossible to predict. The study of finance is subsumed under

economics as financial economics, but the scope, speed, power relations and
practices of the financial system can uplift or cripple whole economies and the
well-being of households, businesses and governing bodies within them
sometimes in a single day.

FINANCIAL MATHEMATICS

Financial mathematics is a field of applied mathematics, concerned with financial

markets. The subject has a close relationship with the discipline of financial
economics, which is concerned with much of the underlying theory.
Generally, mathematical

finance will

derive,

and

extend,

the mathematical or numerical models suggested by financial economics. In terms

of practice, mathematical finance also overlaps heavily with the field
of computational finance (also known as financial engineering). Arguably, these
are largely synonymous, although the latter focuses on application, while the
former focuses on modeling and derivation (see: Quantitative analyst). The field is
largely focused on the modelling of derivatives, although other important subfields
include insurance mathematicsand quantitative portfolio problems. See Outline of
finance: Mathematical tools; Outline of finance: Derivatives pricing.

EXPERIMENTAL FINANCE

Experimental finance aims to establish different market settings and environments

to observe experimentally and provide a lens through which science can analyze
agents' behavior and the resulting characteristics of trading flows, information
diffusion and aggregation, price setting mechanisms, and returns processes.
Researchers in experimental finance can study to what extent existing financial
economics theory makes valid predictions, and attempt to discover new principles
on which such theory can be extended. Research may proceed by conducting
trading simulations or by establishing and studying the behaviour of people in
artificial competitive market-like settings.

BUSINESS SUSTAINABILITY
Business sustainability is often defined as managing the triple bottom line - a
process by which companies manage their financial, social and environmental
risks, obligations and opportunities. These three impacts are sometimes referred to
as profits, people and planet.
However, this approach relies on an accounting based perspective and does not
fully capture the time element that is inherent within business sustainability. A
more robust definition is that business sustainability represents resiliency over time
businesses that can survive shocks because they are intimately connected to
healthy economic, social and environmental systems. These businesses create
economic value and contribute to healthy ecosystems and strong communities.
Business sustainability requires firms to adhere to the principles of sustainable
development. According to the World Council for Economic Development
(WCED), sustainable development is development that meets the needs of the
present without compromising the ability of future generations to meet their own
needs. So, for industrial development to be sustainable, it must address important
issues at the macro level, such as: economic efficiency (innovation, prosperity,
productivity), social equity (poverty, community, health and wellness, human
rights) and environmental accountability (climate change, land use, biodiversity).
There are a number of best practices that foster business sustainability, and help
organisations move along the path from laggards to leaders. These practices
include:
Stakeholder engagement: Organisations can learn from customers, employees and
their surrounding community. Engagement is not only about pushing out messages,

but understanding opposition, finding common ground and involving stakeholders

in joint decision-making;
Environmental management systems: These systems provide the structures and
processes that help embed environmental efficiency into a firms culture and
mitigate risks. The most widely recognized standard worldwide is ISO 14001, but
numerous other industry-specific and country-specific standards exist;
Reporting and disclosure: Measurement and control are at the heart of instituting
sustainable practices. Not only can organisations collect and collate the
information, they can also be entirely transparent with outsiders. The Global
Reporting Initiative is one of many examples of well-recognised reporting
standards;
Life cycle analysis: Those organisations wanting to take a large leap forward
should systematically analyse the environmental and social impact of the products
they use and produce through life cycle analysis, which measure more accurately
impacts.
Firms that are sustainable have been shown to attract and retain employees more
easily and experience less financial and reputation risk. These firms are also more
innovative and adaptive to their environments.
Example
Tech or financial firms going to a paperless office environment;
A cell phone manufacturer pursuing a conflict-free mineral resource
supply chain
A bank committing to and accomplishing carbon-free operations

Businesses need finance, or money, to pay for their overhead costs as well as their
day to day and variable expenses. Here are three situations when businesses need
finance the most:
Starting a business: Huge amounts of finance is needed to start a business which
requires buying fixed assets, paying rent and other overheads as well as producing
or buying the first products to sell. The finance required to start up a business is
called start-up capital.
Expanding a business: When expanding, a lot of capital is needed in order to buy
more fixed assets or fund a takeover. Internal growth by developing new products
also requires a notable amount of finance for R&D.
A business in difficulties: For example, for loss making businesses money is
needed to buy more efficient machinery, or money is needed to cover negative cash
flow. However, it is usually difficult for these firms to get loans.
All all cases, businesses need finance for either capital expenditure or revenue
expenditure:
Capital expenditure: Money spent on fixed assets.
Revenue expenditure: Money spent on day-to-day expenses.

SOURCES OF FINANCE
There are many ways to obtain finance, and they can be grouped in these ways.:
Internal Or External.
1. Short-term, medium-term or long-term.

INTERNAL FINANCE:
This is finance that can be taken from within the business itself. There are
advantages and disadvantages to each of them:
Retained Profit: Profit reinvested into a business after part of the net profit has
been distributed to its owners.
1.
2.
3.
4.

Retained profit does not have to be repaid unlike a loan.

New businesses do not have much retained profit.
Retained profit from small firms are not enough for expansion.
Reduces payment to owners/shareholders.

Sale Of Existing Assets: Firms can get rid of their unwanted assets for cash.
1. Makes better use of capital that is not used for anything.
2. Takes time to sell all of these assets.
3. New businesses do not have these assets to sell.
Running Down Stocks: Sell everything in the current existing inventory.
1. Reduces opportunity cost and storage costs of having inventory.
2. Risks disappointing customers if there are not enough stock left.
Owners' Savings: Only applies to businesses that do not have limited liability.
Since the legal identity of the business and owners are the same, this method is
considered to be internal.

1.
2.
3.
4.

Available quickly.
No interest paid.
Limited capital.
Increases risks for owners.

EXTERNAL FINANCE:
This is money raised from individuals or organisations outside a business. It is the
most common way to raise finance.
Issue Of Shares: Same as owners' savings, but only available to limited
companies.
1.
2.
3.
4.

A permanent source of capital that does not have to be repaid.

No interest paid.
Dividends will have to be paid.
Ownership of the company could change hands to the majority shareholder.

Bank Loans: money borrowed from the bank.

1.
2.
3.
4.
5.

Quick to arrange.
Variable lengths of time.
Lower rates offered if a large company borrows large sums.
Must be repaid with interest.
Collateral is needed to secure a loan and may be lost.

Selling Debentures: These are long-term loan certificates issued by limited

companies.
1. These can be used to raise long-term finance, e.g. 25 years.
2. No collateral is required, just the trustworthiness of a big company.
3. Must be repaid with interest.
Factoring Of Debts: Some businesses (debt factors) "buy" debts of a firm's
debtors (e.g. customers) and pay the firm cash in return. The firm now does not

worry about worrying about whether their customers will pay or not and 100% of
all the debts goes to the factor. Factoring debt is very difficult for me to understand
1. Immediate cash is obtained.
2. Risk of collecting debt becomes the factor's.
3. The firm does not receive 100% value of the debt.
Grants And Subsidies: can be obtained from outside agencies like the
government.
1. Do not have to be repaid.
2. They have conditions that you have to fulfill (e.g. locating in poor areas).

SHORT-TERM FINANCE
This is working capital required to pay current liabilities that is needed up to three
years. There are three main ways of acquiring short-term finance:
Overdrafts: Allows you do draw more from your bank account than you have.
1.
2.
3.
4.
5.

Overdrafts can vary every month, making it flexible.

Interest only needs to be paid only to the amount overdrawn.
They can turn out cheaper than loans.
Interest rates are variable, and often higher than loans.
The bank can ask for the overdraft back immediately anytime.

Trade Credits: Delaying payment to your creditors, which leaves the company
with better cash flow for that month.
1. It is almost a short-term interest free loan.
2. The supplier could refuse to give discounts or to supply you at all if your
payments are delayed too much.
3. Factoring of debts

TYPES OF FINANCE
Most new businesses use a mixture of finance - savings, borrowing from friends or
family, personal loans and bank borrowing. Overdrafts and fixed term loans are
popular. New start-ups can also apply for grants and interest free loans and bigger
businesses with good prospects might attract an outside investor, like a business
angel. Raising money from shareholders may also be an option. If you are short of
cash at the outset you can consider leasing and hire purchase for vehicles and
equipment, rather than buying. If your business has lots of unpaid invoices you
may want to consider invoice financing. All methods of finance bring their own

advantages and disadvantages and you should take advice before making a
decision.
1. Bank Finance Loan Or Overdraft?
It is increasingly difficult to borrow from banks even with a good track record.
Since the credit crunch began, banks have been trying to increase deposits and are
not keen to lend. Rates are high and banks are nervous about losing yet more
money. So you will have to be a good risk before a bank will part with any cash.
Before lending, a bank will want to see a credible business plan, evidence of a
successful track record in business (this is often the chicken and egg situation for
start-ups how can you establish a good track record without borrowing money to
start?). You will have to offer security for any money lent (either business assets or
personal guarantee) and you will have to show commitment by investing your own
money as well. Increasingly banks expect you to invest larger percentages of your
own money before they will commit. If they will commit at all.

2. OVERDRAFTS

These are very useful for financing temporary or fluctuating cash shortages and are
generally a flexible way of funding day to day requirements. Interest is paid only
on the amount you are overdrawn each day. But they have higher interest rates than
loans, and exceeding your overdraft limit is costly. In theory, the bank could
demand repayment any time even 24 hours notice.
3. Loans

Loans are often the best way to finance a longer term business needs. They are
usually fixed for one to ten years (although mortgages and some other loans may
be for as long as 25 years). Repayments are agreed in advance so at least you can
match the term of a loan to your requirements and can budget for repayments. On
the downside there is no flexibility - if you are not using the funds you will still
pay interest. You may also have to offer security.
4. Costs
Costs can vary widely. Both overdrafts and loans are set at a margin over the bank
base rate (which itself fluctuates). You will probably pay an arrangement fee to set
up the loan or overdraft, usually about 1.25% of the total amount requirement.
Sometimes you may have to pay a renewal fee if an overdraft facility is extended
and you may also have to pay costs arranging security.
Banks will look at your business assets, but you will not get more than 80% of the
value of the business property (and realistically quite a lot less). Any equipment
will only be valued at resale price usually its price at auction. Banks may lend up
to 60% of the value of your trade debtors, but will not be interested in old debts or
small debts which are difficult to collect. Any other loans, factoring services or
leasing arrangements will also reduce the amount of security you can offer the
bank and therefore the amount they will lend.

FINANCE FROM OUTSIDE INVESTORS

1. Shareholders
You could issue ordinary shares (standard shares with no special rights or
restrictions) to investors in return for money. Unlike loans and overdrafts you do
not normally have to make payments to investors until the business can afford
them. In addition shareholders might bring in additional expertise, and will share

the decline if your business fails. In addition if you increase the capital invested in
the business it might be easier to borrow from the bank.
On the downside your share of the business and its profits will be lower. You might
lose some control if investors want to be involved in how you manage the
company. Investors may want the business structured in a way that makes it easier
to sell their shares in future.
2. Business Angels
Wealthy individuals will typically invest 10,000 or more and may also offer
business expertise. But you are unlikely to interest outside investors unless you can
show a strong track record and credible business plan. Investment will come at a
price they will expect high potential returns to compensate for the risks they are
taking on.
3. Other Venture Capital
Government backed venture capital funds will invest up to 500,000 in English
companies. Check with your local regional development agency for details. Banks
may also be interested.
British Venture Capitalist Association British Venture Capital Association website
www.bvca.co.uk
4. Grants
Grants and government support may be available. You can get subsidised or no
interest loans or cash. Often support schemes provide lots of free advice you might
otherwise have to pay for.

But there may be stiff competition, you will have to meet specific criteria and
usually have to provide funds yourself. Grant applications can be time consuming,
but there is money out there for grabs. See Duports grant section.

SMALL FIRMS LOAN GUARANTEE SCHEME

Businesses which would not normally qualify for a loan can get help.
1. Additional Sources Of Finance
There are small amounts of money micro finance or micro credit can be
available, usually only for businesses setting up in a disadvantaged area or sector
normally not helped by mainstream lenders.

2. Leasing
This can be a good way of financing a vehicle and you have the option of fixing
costs as part of the agreement. Instead of buying you can lease usually for a fixed
period of three to five years. Payments are spread out over the period helping cash
flow. You get full tax relief on lease payments, except for cars costing more than
12,000.
3. Hire Purchase
Used for equipment. You buy the equipment but payments of capital and interest
are spread over a fixed period (usually 35 years). You can claim capital
allowances on the equipment and the interest payments receive full tax relief.
4. Factoring
Factoring can free up the cash tied up in unpaid invoices. Factoring firms normally
give up to 80% of the value of each sales invoice within 24 hours. The firm then
collects outstanding payments on your behalf from your customers. Factoring is
particularly useful for fast growing businesses or those that have very high value
invoices but have to wait 3090 days for customer payment.
5. Invoice Financing
This provides you with finance against invoices that customers have not yet paid.
You can receive up to 85% of the face value of each invoice immediately and the
balance (less charges) when the invoice is paid by the customer. Unlike factoring,
you have to chase up the invoices yourself.
6. Stock Finance
Cash is raised against the value of stock held by a manufacturing company.

7. Security For Borrowings

For any type of borrowing you will need to show you can afford to pay it back and
that you can offer security to ensure the loan is repaid if things go wrong. Security
can take different forms. You might be able to offer:
a personal guarantee from an individual (be aware that if the guarantee is called
on and has been supported by a legal charge over your personal assets, these assets,
including your house, can be at risk)
a guarantee from a third party. This person will be liable for the debt if you
default. Sole traders (and partners) are already personally liable for all business
debts and directors of limited companies may have to provide personal guarantees
in case the company fails
Small Firms Loan Guarantee for start-ups and young businesses that have been
trading for fewer than five years. Run by the Small Business Service this can be
used to guarantee loans of up to 250,000 (turnover must be under 5.6 million),
but you have to pay a premium of 2% a year on the outstanding balance as well as
the repayment terms and interest rates set by the bank or institution you borrow
from, and you may have to take out insurance.

INDEX
Introduction
Concept
Financial Management
How Much Do You Need?
How The Choice Of Finance Made In Business
Financial Economics
Financial Mathematics
Experimental Finance
Business Sustainability
Source Of Finance
Short Term Finance
Types Of Finance
Finance From Outside Investor
Small Form Loan Guarantee Scheme