Nature of Business Finance notes

Nature of Business Finance

  • Meaning of business finance
  • Nature and scope
  • Importance of business finance
  • Relationship with other disciplines

BUSINESS FINANCE NOTES

 

TOPIC

NATURE OF BUSINESS FINANCE

Definition

These are activities which have to do with the provision and management of funds for the satisfactory conduct of a business. It may also be defined as a business activity that is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprise.

As a subject, business finance is the study of problems of providing money when it is needed by a business organization. The management of business finance is also known as financial management described as the utilization of company’s economic resources in such a way as to maximize shareholders wealth i.e. the value of their shareholding in the company

Business finance is the process by which a financial manager/accountant provides finance for business use as and when it is needed.  This provision has to be undertaken on the basis of the needs of a company.  On the other hand, Financial Management is a branch of economies concerned with the generation and allocation of scarce resources to the most efficient user within the economy (or the firm).  The allocation of these resources is done through a market pricing system.  A firm requires resources in form of funds raised from investors.  The funds must be allocated within the organisation to projects that will yield the highest return.

Financial Needs of a Business

  1. Cost of fixed assets;- Finance is required for meeting the cost of fixed assets such as land, building, machinery and other necessaries for establishing a new enterprise.
  2. Cost of current assets:- A firm needs capital to meet its running or operating expenses such as cash, stock of goods, etc.
  3. Cost of promotion;- every business needs capital for meeting the preliminary expenses and assembly of business concern such as legal fees, registration and publication of documents etc.
  4. Cost of financing;- Capital is also required by an organization for paying commission for underwriters, brokerage on securities etc.
  5. Cost of establishing the business;- A firm also needs capital to meet the losses which are incurred in developing the business to a self sustained stage.
  6. Cost of intangible assets;- Capital is required for spending on purchasing patent rights or good will, etc.

Other needs;-

  • Needs Consequent on the Operations of a Company (Basic Needs);-These have to be financed in so far as they arise out of the company’s operations e.g. salaries.
  • Shortages of Cash Brought About By Unforeseeable Circumstances E.G Non Payment By Debtors

These needs have to be financed by short term finances e.g. overdrafts, but this may be against financial prudence rather such needs should be financed by revolving finances in the circular flow.

However, the financial manager must manage his finances using such tools as:

  • Cash budget – statement of expected receipts and payments over a projected period of time – a forecast.
  • Funds flow statement – (Actual).

Variance between actual funds flow with cash budget.  The variance must be managed to keep the company liquid.  On the other hand a financial manager has to meet the company’s strategic/long term needs (long term investment) are useful to the company because:

  1. It influences the company size (assets)
  2. It influences its growth (plough back)
  3. Finances incidental needs.
  4. It influences the company’s long-term survival – this is through continuous investment.

These investments will call for long term financing in form of owners finance (Ordinary Share Capital and Revenue reserves).  This is a base on which other finances are raised.  The company will also use external financing e.g. debts, loans, debentures, mortgages, lease finance etc.  These finances have to be used in acceptable/reasonable financial mix.  This implies that the company’s gearing level is kept low i.e. the relationship between owners and creditors finance.  This should be below 67% otherwise the company may be forced into receivership and subsequently liquidation.  Even then, when using creditors finances a company must consider:

  1. That cost of finance is less than the Return which implies the rate should not be less than the bank interest + inflation + risk.
  2. Economic conditions prevailing – use debt under boom conditions.
  3. Present gearing – if high this will lead to:
  4. Low credit rating
  5. Lowering of the company’s share prices especially to less than Par value – this leads to mass sale of shares – creditors rush to draw their finances and therefore receivership.
  6. Long term ventures have to call for independent feasibility studies before funds are committed i.e.
  7. Assessment of the return – at least should be greater than minimum return + risk + inflation.
  8. Economic life – if uncertain, the return ought to be higher. Such life must allow the company to pay off the loan.

The financial manager must be guided by principles of financial prudence i.e.

  1. He has to consult experts.
  2. He has to involve investment committee
  3. He has to ascertain whether everyone involved in the implementation of the venture has not been left out either during the planning phase or implementation phase.

SCOPE OF FINANCE FUNCTIONS

The functions of Financial Manager can broadly be divided into two:  The Routine functions and the Managerial Functions.

I. Managerial Finance Functions

Require skilful planning, control and execution of financial activities.  There are four important managerial finance functions.  These are:

  1. Investment of Long-term asset-mix decisions;- These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds among investment projects. They refer to the firm’s decision to commit current funds to the purchase of fixed assets in expectation of future cash inflows from these projects.  Investment proposals are evaluated in terms of both risk and expected return. Investment decisions also relates to recommitting funds when an old asset becomes less productive.  This is referred to as replacement decision.
  2. Financing decisions;-Financing decision refers to the decision on the sources of funds to finance investment projects. The finance manager must decide the proportion of equity and debt.  The mix of debt and equity affects the firm’s cost of financing as well as the financial risk.  This will further be discussed under the risk return trade-off.
  3. Division of earnings decision;- The finance manager must decide whether the firm should distribute all profits to the shareholders, retain them, or distribute a portion and retain a portion. The earnings must also be distributed to other providers of funds such as preference shareholder, and debt providers of funds such as preference shareholders and debt providers.  The firm’s dividend policy may influence the determination of the value of the firm and therefore the finance manager must decide the optimum dividend – payout ratio so as to maximize the value of the firm.
  4. Liquidity decision;-The firm’s liquidity refers to its ability to meet its current obligations as and when they fall due. It can also be referred to as current assets management.  Investment in current assets affects the firm’s liquidity, profitability and risk.  The more current assets a firm has, the more liquid it is.  This implies that the firm has a lower risk of becoming insolvent but since current assets are non-earning assets the profitability of the firm will be low.  The converse will hold true. The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are invested in current assets.

II. Routine functions

For the effective execution of the managerial finance functions, routine functions have to be performed.  These decisions concern procedures and systems and involve a lot of paper work and time.  In most cases these decisions are delegated to junior staff in the organization.  Some of the important routine functions are:

  1. a) Supervision of cash receipts and payments
  2. b) Safeguarding of cash balance
  3. c) Custody and safeguarding of important documents
  4. d) Record keeping and reporting

The finance manager will be involved with the managerial functions while the routine functions will be carried out by junior staff in the firm.  He must however, supervise the activities of these junior staff.

THE OBJECTIVES/GOALS OF A BUSINESS

  • Profit maximization – This is a traditional and a cardinal objective of a business. This is so for the   following reasons:
  • To earn acceptable returns to its owners. (i.e. Must not be less than bank rates + inflation + risk)
  • So as to survive (through plough backs)
  • To meet its day to day obligations.
  • To maximize the net worth. the difference between total assets and total liabilities. This is important because:
  • It influences company’s share prices.
  • It facilitates growth (plough backs).
  • It boosts the company’s credit rating.
  • This is what owners claim from the company.
  • To maximize welfare of employees – Happy employees will contribute to the profitability. This includes:
  • Reasonable salaries
  • Transport facilities
  • Medical facilities for the employee and his family
  • Recreation facilities (sporting facilities).
  • Interests of customers – the company has to provide quality goods at fair prices and have honest dealings with customers.
  • Welfare of the society – the company has to maintain sound industrial relations with the society:
  • Avoid pollution
  • Contribution to social causes e.g. Harambee contributions, building clinics etc.
  • Fair dealing with suppliers. A company must:
  • Meet its obligations on time
  • Avoid dishonor of obligations.
  • Duty to the government: A company should:
  • Pay taxes promptly
  • Go by government plans
  • Operate within legal framework.

OVERLAPS AND CONFLICTS

  • Overlaps – when achieving ONE MEANS achieving the other
  • Conflicts – when achieving ONE CANNOT allow the achievement of the other.

Overlaps

  • 4 & 5 – Some of the customers will be members of the Society.
  • 1 & 2 – If a company is profitable it will in most cases increase its net worth.
  • 1 & 6 – if a company maximises its profits, then it will be able to honour its obligations
  • 2 & 5 – Net worth & the society.
  • 3 & 5 – Employees may be the society.
  • 1 & 5 – Profits vs. Society

Conflicts

  • 1 & 4 – Profits vs. Costs
  • 1 & 3 – Profits vs. Costs
  • 1 & 7 – Profits vs. Costs
  • 5 & 7 – High taxes will reduce social benefits
  • 3 & 5 – Costs vs. Appropriated profits
  • 4 & 6 – Better credit terms to customers will not enable the company to pay its creditors

The Main objectives of a business entity are explained in detail below

Any business firm would have certain objectives, which it aims at achieving.  The major goals of a firm are:

  • Profit maximisation
  • Shareholders’ wealth maximisation
  • Social responsibility
  • Business Ethics

a) Profit maximization

Traditionally, this was considered to be the major goal of the firm.  Profit maximization refers to achieving the highest possible profits during the year.  This could be achieved by either increasing sales revenue or by reducing expenses.  Note that:

Profit = Revenue – Expenses

The sales revenue can be increased by either increasing the sales volume or the selling price.  It should be noted however, that maximizing sales revenue may at the same time result to increasing the firm’s expenses.  The pricing mechanism will however, help the firm to determine which goods and services to provide so as to maximize profits of the firm.

The profit maximization goal has been criticized because of the following:

  • It ignores time value of money
  • It ignores risk and uncertainties
  • It is vague
  • It ignores other participants in the firm rather than shareholders

b) Shareholders’ wealth maximization

Shareholders’ wealth maximisation refers to maximisation of the net present value of every decision made in the firm.  Net present value is equal to the difference between the present value of benefits received from a decision and the present value of the cost of the decision.  (Note this will be discussed further in Lesson 2).

A financial action with a positive net present value will maximize the wealth of the shareholders, while a decision with a negative net present value will reduce the wealth of the shareholders.  Under this goal, a firm will only take those decisions that result in a positive net present value.

Shareholder wealth maximisation helps to solve the problems with profit maximisation.

This is because, the goal:

  • Considers time value of money by discounting the expected future cash flows to the present.
  • It recognizes risk by using a discount rate (which is a measure of risk) to discount the cash flows to the present.

c) Social responsibility

The firm must decide whether to operate strictly in their shareholders’ best interests or be responsible to their employers, their customers, and the community in which they operate.  The firm may be involved in activities which do not directly benefit the shareholders, but which will improve the business environment.  This has a long term advantage to the firm and therefore in the long term the shareholders wealth may be maximized.

d) Business Ethics

Related to the issue of social responsibility is the question of business ethics.  Ethics are defined as the “standards of conduct or moral behaviour”.  It can be though of as the company’s attitude toward its stakeholders, that is, its employees, customers, suppliers, community in general creditors, and shareholders.  High standards of ethical behaviour demand that a firm treat each o these constituents in a fair and honest manner.  A firm’s commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to:

  • Product safety and quality
  • Fair employment practices
  • Fair marketing and selling practices
  • The use of confidential information for personal gain
  • Illegal political involvement
  • Bribery or illegal payments to obtain business.



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