Table of Contents
Facts About Business Finance
What is business finance?
Business Finance or Corporate finance, is raising and managing of funds through corporate associations.
Planning, analysis and control operations are the responsibility of the finance manager, who is usually located near the top of a company’s organizational structure.
In very large companies, major financial decisions are often made by a finance committee. In small companies, the owner-manager usually conducts financial operations.
Much of the day-to-day work of corporate or Business Finance is performed by lower-level employees. Their work includes processing cash receipts and disbursements, borrowing from commercial banks on a regular and ongoing basis, and formulating cash budgets.
Financial decisions affect both the profitability and the risk of a company’s operations. Increasing cash, for example, reduces risk. However, because cash is not an asset, converting other types of assets to cash reduces the profitability of the business.
Similarly, using additional debt can increase a company’s profitability (because it is expanding its business with borrowed money), but more debt means more risk. It is the job of finance to strike a balance between risk and profitability that preserves the long-term value of a company’s securities.
Business Finance: The Basics
Every serious business owner should be able to know basic accounting principles, even if they have to hire an accounting firm or expert to help with their accounting books. This knowledge benefits the other essential aspects of running a successful business.
For small businesses, there are many software programs that can help business owners learn not only about business finance basics like accounting, but also about the following:
Daily expense tracking: An owner needs to be able to run and analyze reports to know where their money is coming from and where it is being spent. The ability to generate reports and demonstrate financial accountability is key.
Introduction to Accounts Receivable and Accounts Payable:
An owner must be able to recognize when payment is expected and anticipate expenses.
Trend: keeps business owners aware of trends in their industry so they can plan accordingly.
This can ensure small business survival in a turbulent market or economy.
Another basic option for business financing is to establish a long-term financial relationship with a trusted funding partner or source. Such an advisor will ensure that your business receives the guidance it needs to stay on track at all times.
When the need for additional working capital arises, you and your business can demonstrate a track record of success and have faster access to the funding you need.
Short-term financial transactions
Financial planning and control
Short-term financial transactions are closely related to a company’s financial planning and control activities. These include financial ratio analysis, profit planning, financial forecasting, and budgeting.
Analysis of financial ratios
A company’s balance sheet contains many items that have no clear meaning on their own. Analyzing financial ratios is one way to evaluate their relative importance.
For example, the ratio of current assets to current liabilities gives the analyst an idea of the extent to which the company can meet its short-term obligations. This is known as the liquidity ratio.
Financial leverage ratios (such as debt-to-asset ratios and debt as a percentage of total capitalization) are used to assess the benefits of raising funds by issuing bonds (debt) instead of stock.
Activity ratios, which refer to the turnover of asset categories such as inventories, receivables, and fixed assets, show how intensively a company uses its assets.
The primary operating objective of a company is to achieve a good return on its invested capital. Various profit ratios (profits as a percentage of sales, assets, or net assets) show how successful it is in achieving this goal.
Ratio analysis is used to compare the performance of a company with that of other companies in the same industry or with the performance of the industry in general. It is also used to examine trends in company performance over time to anticipate problems before they develop.
Ratio analysis applies to a company’s current operating position. However, a company must also plan for future growth. This requires decisions about expanding existing operations and, in manufacturing, developing new product lines.
A company must choose between productive processes that require different levels of mechanization or automation, i.e., different amounts of fixed capital in the form of machinery and equipment. This increases fixed costs (costs that are relatively constant and do not decrease when the company operates at a level below full capacity).
The higher the proportion of fixed costs to total costs, the higher the level of operation must be before profit begins to accrue, and the more sensitive profit will be to changes in the level of operation.
Business Finance – Financial Forecast
The financial manager must also prepare general forecasts of future capital requirements to ensure that funds are available to finance new capital programs. The first step in preparing such a forecast is to obtain a revenue estimate for each year of the planning period.
This estimate is developed jointly by the marketing, production and finance departments: The marketing manager estimates demand; The production manager estimates capacity. The finance manager estimates the availability of funds to finance new receivables, inventory, and fixed assets.
For the projected level of sales, the finance manager estimates the funds that will be available from the company’s operations and compares that amount to what will be needed to pay for the new fixed assets (machinery, equipment, etc.).
If the growth rate exceeds 10 percent per year, asset requirements will likely exceed internal funding sources. Therefore, plans must be made to finance through the issuance of securities.
On the other hand, if growth is slow, more funds will be generated than are needed to support the estimated revenue growth.
In this case, the financial manager will consider a number of alternatives, including increasing dividends to shareholders, paying down debt, using excess funds to acquire other businesses, or possibly increasing spending on research and development.
Once a company’s overall goals for the planning period have been established, the next step is to create a detailed operating plan – the budget. A complete budget system includes all aspects of the company’s operations during the planning period. It may even allow for changes to the plan that are required due to factors beyond the company’s control.
Budgeting is part of the company’s overall planning activity and therefore must begin with an explanation of the company’s long-range plan. This plan includes a long-term sales forecast that requires a determination of the number and type of products to be produced during the years covered by the long-term plan.
Short-term budgets are formulated as part of the long-term plan. Typically, there is a budget for each individual product and for each major activity of the company.
Establishing budgetary controls requires a realistic understanding of the company’s activities. For example, a small company will buy more parts and use more labor and less machinery. A larger company will buy raw materials and use machinery to produce finished products.
As a result, the smaller company should budget for higher parts and labor expense ratios, while the larger company should budget for higher overhead ratios and greater investment in fixed assets.
When standards are unrealistically high, frustration and resentment result. When standards are excessively lax, costs spiral out of control, profits suffer, and employee morale plummets.
The cash budget
One of the most important methods of forecasting a company’s financial needs is the cash budget, which predicts the combined impact of planned operations on the company’s cash flow.
A positive net cash flow means that the company has excess cash to invest. However, if the cash budget indicates that an increase in operating volume will result in negative cash flow, additional financing will be required. Thus, the cash budget indicates the amount of funds needed or available on a month-to-month or even week-to-week basis.
A business may have excess cash for several reasons. It is likely that there are seasonal or cyclical fluctuations in the business. Resources may be intentionally accumulated as protection against a range of contingent liabilities.
Since it is wasteful to leave large amounts of cash idle, the financial manager will try to find short-term investments for amounts that will be needed later. Short-term government or commercial securities can be selected and balanced to provide the financial manager with maturities and risks appropriate to a company’s financial situation.
Business Finance – Receivables
Receivables are the loans that a company grants to its customers. The volume and terms of such loans vary among companies and nations. For manufacturing companies in the United States, for example, the ratio of accounts receivable to sales ranges from 8 to 12 percent, which corresponds to an average collection period of about one month.
The basis of a company’s credit policy is the practice in its industry. Generally, a company must meet the terms offered by competitors. Much depends, of course, on the creditworthiness of the individual customer.
To evaluate a customer as credit risk, the credit manager considers what is known as the five Cs of credit: Character, Capacity, Capital, Collateral, and Conditions.
Information on these items comes from the company’s past experience with the customer, supplemented by information from various credit associations and credit bureaus. (See credit bureau.) In reviewing a credit program, the financial manager should consider losses from bad debts as part of the cost of doing business.
Accounts receivable represent an investment in revenue expansion. The return on this investment can be calculated as in any capital budget problem.
Every business must maintain inventories of goods and materials. The level of investment in inventory depends on several factors, including the level of sales, the nature of production processes, and the rate at which goods spoil or become obsolete.
The issues involved in managing inventory are essentially the same as those involved in managing other assets, including cash. A basic inventory must be available at all times.
Since the unexpected can occur, it is also advisable to have safety stocks. These represent the little extra needed to avoid the cost of not having enough. Additional amounts – anticipation stock – may be needed to meet future growth requirements.
Finally, some inventory accumulation results from the savings of buying in bulk. It is always cheaper to buy more than is needed immediately, whether it is commodities, cash, or equipment.
There is a standard procedure for determining the most economical order quantities that relates purchasing requirements to costs and transportation costs (i.e., The cost of carrying an inventory).
While book costs increase as average inventory increases, certain other costs (ordering costs and storage costs) decrease as average inventory increases.
These two sets of costs represent the total cost of ordering and inventory, and it is fairly straightforward to calculate an optimal order size that minimizes total inventory costs.
The advent of computerized inventory tracking encouraged a practice known as just-in-time inventory management, thereby reducing the likelihood of excessive or insufficient inventory.
The main sources of short-term financing are (1) trade credit, (2) commercial bank loans, (3) commercial paper, a specific type of promissory bill, and (4) secured loans.
Business Finance – Trade Credit
A business typically purchases its supplies and materials on credit from other businesses and records the debt as a liability. This trade credit, as it is commonly called, is the largest single category of short-term credit. Credit terms are usually expressed with a discount for immediate payment. Therefore, the vendor may state that a 2 percent discount will be given for payment within 10 days of the invoice date.
If the discount is not taken, payment is due 30 days after the invoice date. The cost of not taking discounts is the price of the credit.
Commercial bank loans
Lending to commercial banks is shown on the balance sheet as debt securities and is second only to trading in loans as a source of short-term funding. Banks occupy a central position in the short- and medium-term money markets. As a company’s financing needs increase, banks must provide additional funds.
An individual loan obtained by a company from a bank is in principle no different from a loan obtained by an individual. The company signs a conventional promissory bill.
Repayment is made in a lump sum when due or in installments over the life of the loan. A line of credit, which is different from an individual loan, is a formal or informal agreement between the bank and the borrower on the maximum loan balance the bank will allow at any given time.
Commercial paper, a third source of short-term credit, consists of promissory bills issued by established businesses and sold primarily to other businesses, insurance companies, pension funds, and banks.
Commercial paper is issued for periods ranging from two to six months. Interest rates on prime commercial paper vary, but are generally slightly lower than interest rates on prime commercial loans.
A fundamental limitation of the commercial paper market is that its resources are limited to the excess liquidity that corporations, the primary suppliers of funds, may have at any given time.
Another disadvantage is the impersonal nature of the business; a bank is much more likely to help a good customer weather a storm than a commercial paper dealer.
Most short-term business loans are unsecured, meaning that an established business’s credit rating qualifies it for a loan. It is usually better to borrow on an unsecured basis, but often a borrower’s credit rating is not strong enough to justify an unsecured loan. The most common types of collateral for short-term loans are accounts receivable and inventory.
Financing through accounts receivable can be done either by pledging the receivables or by selling them outright, which in the U.S. is called factoring. When a receivable is pledged, the borrower retains the risk that the person or company owing the receivable will not pay; this risk is usually passed on to the lender in factoring.
When loans are secured by inventory, the lender takes ownership of them. He may or may not take physical possession of them. Under field storage, inventory is subject to the physical control of a storage company, which releases the inventory only when ordered by the lending institution.
Canned goods, lumber, steel, coal, and other standardized products are the types of goods typically covered in field storage agreements.
While short-term loans are repaid within weeks or months, medium-term loans are to be repaid in 1 to 15 years. Obligations maturing in 15 or more years are considered long-term debt. The major forms of intermediate-term financing include (1) term loans, (2) conditional sales contracts, and (3) lease financing.
Business Finance – Term Loan
A term loan is a business loan with a term of more than 1 year but less than 15 years. Usually, the term loan is repaid over its term through systematic repayments (amortization payments).
It may be secured by a chattel mortgage for equipment, but larger, stronger companies may borrow on an unsecured basis. Commercial banks and life insurance companies are the main suppliers of term loans.
Interest costs on term loans vary with the size of the loan and the strength of the borrower.
Term loans carry more risk to the lender than short-term loans. The lender’s funds are tied up for a long period of time, and during that time the borrower’s situation can change significantly.
To protect themselves, lenders often include in loan agreement provisions that the lending company maintain its current liquidity ratio at a certain level, limit purchases of fixed assets, keep the debt ratio below a specified amount, and generally follow acceptable guidelines to the lending institution.
Conditional sales contracts
Conditional sales contracts are a common method of obtaining equipment by agreeing to pay for it in installments over a period of up to five years. The seller of the equipment retains ownership of the equipment until payment is completed.
It is not necessary to purchase assets in order to use them. For example, railroads and airlines in the U.S. have acquired much of their equipment through leases. Whether leasing is advantageous depends on the company’s access to funds, aside from tax benefits.
Leasing offers an alternative method of financing. However, a lease is a fixed obligation, resembles debt, and uses some of the company’s carrying capacity. It is generally advantageous for a business to own its land and buildings because their value is likely to increase, but the same opportunity for appreciation does not apply to equipment.
It is often said that leasing involves higher interest rates than other forms of financing, but this need not always be true. Much depends on the company’s position as a credit risk.
In addition, it is difficult to separate the cash cost of leasing from the other services that may be included in a lease. If the leasing company can provide nonfinancial services (such as equipment maintenance) at a lower cost than the lessee or someone else, the effective lease cost may be lower than other financing methods.
Although leasing has a fixed cost, it allows a company to present a lower debt-to-asset ratio in its financial statements. Many lenders place less emphasis on a lease obligation than a loan obligation when reviewing financial statements.
Long-Term Financial Transactions
Long-term capital can be raised either by borrowing or by issuing stock. Long-term borrowing is accomplished through the sale of bonds, which are promissory notes that obligate the company to pay interest at specified times.
Secured bond-holders have a prior claim on the assets of the company. If the company ceases to operate, the bond-holders are entitled to payment of the nominal value of their holdings plus interest.
Shareholders, on the other hand, have only a residual claim on the company; they are entitled to a share of the profits if any, but it is the prerogative of the board of directors to decide whether and how much to pay out in dividends.
For long-term financing, a choice is made between debt (bonds) and equity (shares). Each company chooses its own capital structure and looks for a combination of debt and equity to minimize the cost of raising capital.
As capital market conditions change (e.g., changes in interest rates, availability of funds, and relative costs of alternative financing methods), the company’s desired capital structure will change accordingly.
The higher the proportion of debt in the capital structure (leverage), the higher the return on equity. This is because the bondholders do not share in the profits.
The difficulty, of course, is that a high proportion of debt increases a company’s fixed costs and increases the degree of variation in the return on equity for a given degree of variation in the level of sales.
When used successfully, leverage increases the return to owners but decreases the return to owners when it is not used successfully. If leverage is unsuccessful, it can lead to bankruptcy of the company.
There are various forms of long-term debt. A mortgage bond is secured by a lien on tangible assets such as property, plant, and equipment. A debenture is a bond that is not secured by specific assets but is accepted by investors because the company has a high credit rating or agrees to follow policies that ensure a high rate of return.
An even more recent lien is the subordinated debenture, which is subordinated to all other debentures and especially short-term bank loans (in terms of the ability to recover capital in the event of a business liquidation).
Periods of relatively stable sales and earnings encourage the use of long-term debt. Other conditions that favor the use of long-term debt include high-profit margins (making additional leverage beneficial to shareholders), an expected increase in profit or price levels, a low debt ratio, and a relatively low price-to-earnings ratio on interest rates and borrowings that do not severely constrain management.
Equity financing uses common and preferred stock. While both forms of stock represent ownership interests in a company, the preferred stock generally has priority over common stock in terms of profits and asset claims in the event of liquidation.
Preferred stock is usually cumulative – that is, the omission of dividends in one or more years results in a cumulative claim that must be paid to holders of preferred stock.
Dividends on preferred stock are usually set at a certain percentage of par value. A company that issues preferred stock benefits from limited dividends and no maturity, i.e., the advantages of selling bonds but without the limitations of bonds.
Companies sell preferred stock when they seek more leverage but want to avoid the fixed cost of debt. The benefits of preferred stock are amplified when a company’s debt ratio is already high and common stock is relatively expensive to finance.
If a bond or preferred stock issue was sold when interest rates were higher than they are now, 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 compared with the annual savings that can be achieved.
Earnings and dividend policy
The size and frequency of dividend payments are important issues in corporate policy. Dividend policy affects the financial structure, cash flow, corporate liquidity, stock prices, and shareholder morale.
Some shareholders prefer to receive maximum current returns on their investment, while others prefer reinvestment of profits so that the company’s capital increases.
However, when profits are paid out as dividends, they cannot be used to expand the company (which affects the company’s long-term prospects). Many companies have chosen not to pay shareholders regular dividends, but to pursue strategies that increase the value of the stock.
Companies tend to reinvest more of their earnings when there are opportunities for profitable expansion. In times of high profits, reinvested amounts are higher and dividends are lower. For similar reasons, when profits fall, reinvestment is likely to fall and dividends are likely to rise.
Companies that have relatively stable earnings over a period of years tend to pay high dividends. Established large companies are likely to pay higher than average dividends because they have better access to capital markets and are less dependent on internal financing. A company with a strong cash or liquidity position is also likely to pay higher dividends.
However, a company with high debt has an implicit commitment to pay relatively low dividends. Income must be retained to service the debt.
There may be advantages to this approach. For example, if a company’s directors want to retain control of the company, they can retain profits to fund expansion without having to issue shares to outside investors.
Some companies prefer a stable dividend policy rather than allowing dividends to fluctuate with earnings.
The dividend rate is then lower when profits are high and higher when profits temporarily decline. Companies whose shares are held closely by a few high-income shareholders are likely to pay lower dividends to reduce shareholders’ individual income taxes.
In Europe, until recently, corporate financing generally relied heavily on internal sources. This was because many companies were owned by families and also lacked a highly developed capital market.
In today’s less developed countries, companies rely heavily on internal financing but are also more likely to use short-term bank loans, microcredit, and other forms of short-term financing than is common in other countries.
Convertible bonds and warrants
Companies sometimes issue bonds or preferred stock that give holders the option of converting them into common stock or buying shares at bargain prices. Convertible bonds offer the opportunity to convert into common stock at a specified price during a specified period of time.
Stock purchase warrants are given with bonds or preferred stock as an incentive to the investor because they allow the purchase of the company’s common stock at a specified price at any time.
Such option privileges make it easier for small companies to sell bonds or preferred stock. They help large companies place new issues on more favorable terms than they could otherwise obtain. When bondholders exercise conversion privileges, the company’s debt ratio is reduced as bonds are replaced by stock.
Exercising warrants, on the other hand, bring additional funds into the company but leaves an existing debt or preferred stock on the books.
Warrant privileges also allow a company to sell new stock at lower prices than at the time of issuance because the prices indicated on the warrants are higher. Stock purchase warrants are therefore most popular at times when stock prices are expected to trend upward.
Growth and decline
Business Finance – Mergers
Companies often grow by combining with other companies. One company may buy all or part of another company. two companies may merge by exchanging stock, or an entirely new company may be formed by consolidating the old companies.
From the financial manager’s point of view, this type of expansion is like any other investment decision. The acquisition should be made when it increases the cash value of the acquiring company, which is reflected in the price of its stock.
The most important term to negotiate in a combination is the price the acquiring company will pay for the assets it acquires.
Current earnings, expected future earnings, and the impact of the combination on the earnings growth rate of the surviving firm may be the most important determinants of the price to be paid.
Current market prices are the second most important determinant of merger prices. Depending on whether the assets indicate the earning power of the acquired firm, book values may have an important influence on the terms of the merger.
Other, non-measurable factors are sometimes the key determinant of mergers. Synergies (where net income is greater than the combined value of the individual components) can be attractive enough to justify paying a price that is higher than earnings and assets would indicate.
The basic requirements for a successful merger are that it fits into a sound long-term plan and that the performance of the resulting company is superior to those that can be achieved independently by the previous companies.
In the difficult environment of an emerging stock market, mergers have often been motivated by superficial financial goals. Companies with stock selling at a high price relative to earnings have found it advantageous to merge with companies with lower price-to-earnings ratios. This allows them to increase their earnings per share and thus appeal to investors who buy shares based on earnings.
Some mergers, particularly those of conglomerates that bring together companies in unrelated fields, owe their success to management economies developed during the 20th century.
New strategies emphasized the importance of general management functions (planning, control, organization, and information management) and other top-level management functions (research, finance, legal, and technology).
These changes reduced the cost of managing large, diversified companies and led to an increase in mergers and acquisitions among companies around the world.
In a merger, one company disappears. Alternatively, a company can buy all (or a majority) of the voting stock of another company and then run that company as an operating subsidiary. The acquiring company is then called a holding company.
The holding company offers several advantages: it can control the acquired company with a smaller investment than would be required in a merger.
Each company remains a separate legal entity, and the obligations of one are separate from those of the other. and finally, shareholder approval is not required – as in the case of a merger.
Holding companies also have disadvantages, including the possibility of multiple taxations and the risk that high leverage will amplify profit fluctuations (whether losses or gains) of operating companies.
When a business cannot operate profitably, the owners may try to reorganize it. The first question that must be answered is whether the company might not be better off if it ceases operations. If the decision is made that the business should survive, it must be subjected to the restructuring process.
Legal proceedings are always costly, especially in the case of business failure. Both the debtor and the creditors are often better off settling matters informally than through the courts. The informal procedures in restructuring are (1) extension, which defers settlement of outstanding debts, and (2) composition, which reduces the amount owed.
If voluntary settlement by extension or composition is not possible, the matter must go to court. If the court decides on restructuring rather than liquidation, it appoints a trustee to control the company and prepare a formal restructuring plan.
The plan must meet standards of fairness and feasibility. The concept of fairness involves the appropriate distribution of proceeds to each claimant, while the feasibility test relates to the ability of the new entity to bear the fixed charges resulting from the restructuring plan.
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