Finance and Business Finance
Finance and Business Finance
With the gradual progress of society & civilization and the development of science and technology, the scope of trade and commerce has also increased. Hence, the product market has to cope with diverse competition. To make a profit in this competition, a businessman has to utilize his capital efficiently through proper planning so that the cost of production or selling could be kept minimum. Hence, a business firm can maximize its profit. For that purpose, every business firm collects its necessary fund for investment from the most desirable sources and invests them in the most suitable project by analyzing various information about the product market.
This creates inflows and outflows of funds in the business. Finance regulates these flows of funds nicely. Different principles of finance are used in this process of regulation. Financial Management helps a businessman to earn enough profit from investing even a small amount of capital. Nowadays finance is no more used as a supporting system but as the main driving force of business.
Concept of Finance
Finance deals with fund management. Finance prepares plans and implements necessary activities about what amount of funds should be collected from which sources and where & how this fund is to be invested for the highest profit in the project. In the case of a business firm, fund flows in the business from the selling of products. Different types of funds are needed to produce and buy goods for the business, like- purchasing machinery, purchasing raw materials, paying wages to the laborers, etc. These are the utilization of funds. Funds need to be collected in a planned way as per the requirement of funds to maintain an uninterrupted production process. Finance means this process is related to fund collection and utilization.
If you visit a tailoring shop in your locality, you will see there one or two people sewing with a machine. Again, someone may be cutting clothes or stitching the buttons. So to continue the tailoring business properly, the shop owner has to purchase machines, threads, buttons, scissors, etc. of the necessary amount. At the beginning of his business, he bears these expenses from his own saving. If the fund appears insufficient, then he may take a loan from his relatives to overcome the shortage. When the business is in operation, at the end of every month he needs to bear expenses for the payment of workers’ wages, house rent, electricity bill, etc. and he pays all these with the money earned by sewing clothes. He also has to plan to pay back the loan money from this monthly collection. An owner of a tailoring shop always expects that he can earn some amount of profit even after meeting all necessary expenditures from the income of the business, by which he can save for the future or can utilize for business expansion even after meeting the regular expenses of his family. So if an owner of a tailoring shop conducts business through proper planning regarding the source of finance and its utilization, only then he can earn profit through the smooth operation of the business.
Otherwise, it will be found that due to cash crises sewing thread cannot be bought timely and the customers are returning. Again, it may be needed to shut down the business due to a lack of money to buy a new machine to replace the old one. To conduct the business properly, Business finance deals with when and for what reason how much amount of fund is needed, and from which sources this fund should be collected for smooth operation of the business.
There have implications for finance in the family too. Generally, every family has one or more than one source of finance. Income may be obtained from different sources in different families, such as, from service, business, agricultural activities, self-employment, etc.
Besides these, regular expenditure of a family occurs for daily shopping costs, house rent, school fees, different bills payment, etc. As expenditure should be matched with income, in this way, the right time of expenditure should also be maintained. If money is insufficient as per demand, then as an example, it may happen that name of the student may be cut down from the register. In the case of a family, pre-planned identification of the sources of finance and its utilization is the financial process. Other than daily expenditure of this type, sometimes occasional expenditure may be required in the family which may exceed the income ability of a person. If it is not possible to collect money from regular income sources for such expenditures as buying a new television or refrigerator, then the shortage may be fulfilled through a long-term loan. In that case, a loan repayment plan needs to be prepared. As a result, the concept of finance helps to determine the sources of funds and make proper management of it to conduct the family smoothly.
The financial process can be understood from the perspective of a school also. School is a social organization whose main objective is not profit earning, there also has a plan of income- expenditure and fund management. Educational institutions generally collect funds from sources of their student’s tuition fees, examination fees, admission fees, etc. The institution has to meet different expenditures with this fund to run the academic activities properly, like- payment of teacher-staff salary, house rent, electricity bill, different types of renovation expenses, and purchasing computers and furniture. So, ensuring fund management for performing various working processes of the institution nicely by considering different sources of funds and different sectors of utilization is financing from the perspective of the school.
Among the above examples, a tailoring shop is a profit-making organization, but family and school are non-profit organizations. Our present topic is involved mainly in the financing of profit-making- or business organizations. How is the financial process of a grocery shop? The shop owner earns a profit by selling products. But for the purpose of selling, he needs to complete on a regular basis purchasing products, paying rent, electricity bill, wages of the workers, etc. as current expenditures. Moreover, sometimes he has to spend a large amount of money for purposes like- expansion of business for the need of the customers, purchasing a refrigerator, etc. These are his fixed expenditure. Thus a grocer requires to invest both in fixed assets and current assets. If income from selling is not sufficient for collecting funds for investment, he has to collect funds from other sources like personal funds, friends-relatives, purchases on credit, etc. Again, he may collect large amounts of money which he needs to invest in fixed assets usually from commercial banks. In such financing, as there is the opportunity of repaying over a long schedule of time, the risk of loan repayment is reduced a bit. In the case of a grocery shop, the main activities of business finance are fund management through proper utilization of money received from sales proceeds in meeting current expenditures, some long-term investments, collection of money from less risky sources, timely repayment of loan installments, etc.
Square Pharmaceuticals, Bata Company, Kohinoor Chemicals – these are large size business organizations that are called companies. The financial process of such a company is not as simple as a grocery shop or tailoring shop rather it is comparatively complex.
In fund collection, a large company gets more benefits than a small organization. For example, a company collects capital by selling shares in the share market. A company’s goodwill, rate of profit, customer services, or consumer satisfaction helps to increase the share price in the share market. Business finance deals with and provides guidance regarding: from among different sources using which source, when and how much fund should be collected and in which sectors, how much amount and how will it be invested to increase the profit.
Classification of Finance
The financial process is as important for a business organization as so important for a nonprofit organization too. Every organization is involved in a financial process. The financial process takes different forms for different organizations. Now we will discuss the classification of this finance. Though our main concentration is business finance, we will also get a brief idea of the financial processes of some other organizations also.
a) Family Finance
In family finance, the sources and amount of income of the family are identified and how this income can be utilized for the overall welfare of the family members is determined. Among numerous necessary expenditures, the most important expenditures are fulfilled on a priority basis. If family income is not sufficient, the loan can be taken from relatives, familiar persons, or friends. Regular expenditures are determined by considering the regular income. Bank loans can be arranged for fixed assets like television, freeze, car, building construction, etc. But, as the collected fund is limited, it needs proper utilization. If the collected money is in excess, the remaining amount can be saved for future use.
b) Public Finance
Every government has its own financial management. In the case of a government, how much in what areas will be the probable yearly expenditures of the government, and how that money can be arranged from which sources are discussed in public finance. Government has to spend a lot of money for the overall development of the country in various sectors like- roads, bridges, government educational institutions, government hospitals, law and order, defense, social infrastructure, etc. The government collects money to bear these expenses from different sources like- income tax, tat, gif tax, import custom, export custom, saving certificates, prize bonds, treasury bills, etc. In public finance, first, the amount of expenditure is determined and then the fund is collected according to the needs. The main objective of public finance is social welfare. Public finance is usually non-profitable. Expenditure may be greater than income in public finance. There exist a number of business organizations under government ownership, which may be less profitable also, for example, chemical industries under BCIC.
Again, a large amount of money is required for big projects like Jamuna Bridge, if the total amount of money is collected from the government budget. On many occasions, financial crises may occur to the government due to public expenditure for social and state security. For that reason, many times the government collects foreign loans from organizations like ADB (Asian Development Bank), World Bank, IDB (Islamic Development Bank), etc.
But at the time of sanctioning the loan, such organizations impose different types of conditions, which may not be consistent with the need for the country’s development and image protection. Considering these conditions, the government wants to collect funds from other sources. Nowadays, big projects are financed worldwide and also in our country through public-private cooperation. This type of arrangement is called PPP (Public Private Partnership).
c) International Finance
In international finance, the export and import sectors are discussed and analyzed. Bangladesh is mainly an import-oriented country. Every year a huge amount of foodstuff, raw materials, machinery, medicine, petroleum, etc. are imported from different countries. On the other hand, jute and jute products, readymade garments, agricultural products, etc. are being exported. Trade deficiency of large amounts occurs as the volume of imports is greater than the volume of export. Remittances sent by foreign dwellers play a vital role to compensate for this deficiency. International finance covers discussion about export and import sectors and the way of management to compensate for the trade deficiency.
d) Finance of Non-Profit Organization
In our society, there are some institutions or organizations which are involved in the welfare of mankind, or providing services for the poor and distressed people. To run this type of business, money or products or services similar to money are required and it is necessary to utilize that money efficiently. In this connection, the role that finance plays is the identification of the sources of finance or wealth similar to money and ensuring its proper utilization for the purpose of achieving service-oriented objectives. As an example it could be mentioned: an orphanage is not a profit-making institution, but it also has a need for finance. These types of institutions collect money through different grants. This collected money is spent on various development activities for the orphans. So source identification and proper utilization of funds to achieve its motto is the main objective of finance of non-profit organizations.
e) Business Finance
The most important type of finance is business finance. An organization formed with the purpose of earning profit through the risk of profit and loss is called a business organization. So, business finance is the process used to collect fund and invest it for business purposes. Business organizations are classified into three types:
Sole Proprietorship Business, Partnership Business, and Joint Capital Business organizations. The general feature of these three types of organizations is fund collection and fund management. For fund collection, own capital and loan are used as sources. Business finance is the main theme of this lesson.
The most famous business organizations in Bangladesh are usually formed as sole proprietorship businesses and partnership businesses. Varieties of small and cottage industries, hotel & restaurant businesses, grocery shops, saloons, boutique shops, etc. are of these kinds of business. In a sole proprietorship business, if profit is earned the owner enjoys it alone, and if any loss occurs the owner’s personal properties also be used to repair the loss.
In a partnership business, the risk is distributed among all partners, so the partners are to be prepared to use personal properties to bear the loss in business (if any). In these types of businesses – sole proprietorship or partnership – sources of finance are the owner’s own capital, profit, loan from relatives, and loan arranged on interest from bank or village money lenders. So, earning profit from investing own funds by proper utilization of money is the main objective of these types of business organizations.
The financial process of a joint stock company is different. Government approval is required to form such a company. Before giving approval, the government evaluates and analyses the minimum amount of capital, directors’ identity, business objectives, and various documents. After getting approval, a company divides its expected big amount of total capital into small portions of equal amounts and sells these as shares in the share market. For example, 1 lac shares of 1000 taka may be sold to the public when the business has a capital of 100 million taka. As each share costs only 1000 taka, small investors from remote places in the country also can purchase shares. Shareholders are the owners of the company and if the company is profitable they usually get dividends on a regular basis. Shareholders can convert their shares into cash by selling those in the share market like Dhaka Stock Exchange. Other than shares, a joint stock business can raise funds by taking loans from the public through selling bonds and debentures to them. In that case, the company has to pay interest on a regular basis at a certain rate to the debenture holders. Because they are not the owners of the company like the shareholders.
f) Bank and Financial Institutions
In any country, economic activities usually revolve centering banks and financial institutions. Sonali Bank, Janata Bank, Rupali Bank, Prime Bank, Shahjalal Islami Bank – These types of government and privately owned banks are profit-oriented organizations but their financial process is usually slightly different from business organizations.
These banks collect small amounts of fund from the people, create a deposit for different terms with this fund, and provides a fixed rate of interest to the depositors. Again, banks provide loans to entrepreneurs in different businesses from this fund. Loans can also be taken for personal purposes. Banks impose interest on certain rates against these loans. But the rate at which a bank receives interest on granted loans is greater than the rate of interest the bank pays to the depositors. This difference between these two rates of interest is the profit of banks. In the banking chapter, we will learn in detail about these institutions. Besides commercial banks, some financial organizations also play an important role in the country’s economic activities. In the Bangladesh context, some examples of these types of organizations are the Investment Corporation of Bangladesh (ICB), Bangladesh House Building Finance Corporation, Bangladesh Agricultural Bank, etc. These financial institutions play their own special roles in the development of different sectors of the economy of Bangladesh.
Importance of Business Finance
In the present competitive open market economy, every government, non-government, and international business institution has to finance with great importance in a preplanned way. Through the use of well-thought and effective financial management, the risks of the institutions are reduced and profits are increased. The following things make financial management more meaningful:
a) Capital Crisis of Business
Finance-related ideas bear special importance in the situation of Bangladesh. As Bangladesh is a poor country, the financial crisis is a regular incident for business organizations. Due to this crisis, running the business smoothly has become very challenging. It could be said as an example, a business organization needs to purchase raw materials, but if it cannot purchase raw materials timely due to the financial crisis then the production process of the organization may be hampered. Finance-related ideas help a business entrepreneur to collect the necessary amount of funds at the right time and utilize it properly in a planned way.
b) Backward Banking System
Besides, as our financial organizations are not well-organized like that of the advanced countries, (usually) loans cannot be arranged within the expected time after application. Sometimes, the loan cannot be arranged as per the required amount due to the insufficiency of property to be pledged as security for sanctioning the loan. So, to overcome this problem, business people have to collect funds at the right time in a very well-planned way and also need profitable utilization of the fund with the right investment decision. A proper financial plan and management help him to predict this type of problem and give an idea about the process of overcoming such a situation.
c) Less Educated Entrepreneur
The majority of the entrepreneurs in Bangladesh are less educated and are not able to conduct financial activities through a long-term plan. So, many profitable business organizations cannot operate smoothly due to the financial crisis arising from improper financial planning, and in the end, it faces loss instead of profit. But, the only reason for this loss is financial ill-management. If a businessman has sufficient knowledge about financial management he can easily collect the necessary amount of funds at the right time from a less expensive source and can earn enough profit by running his business by investing it in a suitable project.
d) Production-Oriented Investment and National Income
A successful investment plays a direct role to increase national income. By applying financial knowledge, a business person can choose the most profitable project from among the alternatives by doing a cost-benefit analysis of the projects under consideration. This type of profitable investment is as much meaningful for the business so much it is important also for the economic development of the whole country.
Principle of Business Finance
Business finance management means fund collection as per requirement, investment of this fund in short and long terms, and the management of fund distribution. This management process follows some principles which are furnished below:
a) Liquidity vs. Profitability Principle
A grocer may keep all the cash money (liquid property) earned from daily sales for the purpose of buying raw materials and other related expenses, or he may keep with him some portion of this cash for buying raw materials and deposit the rest amount in a bank account from which it is possible to get some amount of interest/ profit after a certain period. In this situation, the grocer has to decide on how much-earned cash should be retained with him to meet the current needs. If the grocer keeps a large amount of cash with him to meet the daily expenses then income from the bank will decrease. Again, if a large amount of cash is deposited in a bank, the business may fall into a financial crisis which may hamper daily activities. So, business people have to do financial management in such a way that can create a balance between liquidity and investment. It means, as on one side business people need cash reserve to bear the daily expenses, thus on the other side cash should be invested for making a profit too. There is an inverse relationship between cash and liquidity. Huge cash decreases profitability, again excess investment for the purpose of high profit causes a cash crisis. Maintaining a balance between liquidity and profitability is one of the principles of finance.
b) Competence Principle
Acquiring current assets through short-term funds and fixed assets through the long-term fund –is a principle of finance. The current asset is the money that is required to run the daily expenses of a business, like- raw materials purchase, payment of labor wages, etc. On the other hand, machinery purchase, building construction for the business, etc. are fixed capital. As the amount of current capital is small, it also yields less; for this reason, this type of capital should be collected from a short-term source of finance. Commercial banks, different financial institutions, investment banks, and debenture holders these types of sources provide long-term loans. On the other hand, current capital should be managed from regular sales proceeds. A high rate of interest has to be given to the loan-providing institutions for collecting loans from long-term sources. So, if a loan is collected from long-term sources to bear the current expenses, then it appears that repayment of interest from the earned income becomes impossible.
c) Diversification and Risk Distribution Principle
In the case of fund investment, if business products or services are as much as possible diversified, the risk is distributed and reduced. Every business organization tries to earn profit centering on an uncertain future. So business has to face a lot of risks. These risks may be created for many reasons, like- changes in economic, political, or social scenarios, the arrival of new products in the market, natural calamity, sudden accident, etc. It is not possible for the managers to control these uncertain situations or take preparations for them. But through following the principle of risk distribution, profit is possible to be earned in this uncertain market. If a business person does business only for a single product, then profit earning becomes very risky. On the other hand, if the products of the business are different and diversified, then the risk is distributed. It means, in any situation if the selling of a single product is deteriorate then the decreased amount of profit can be compensated by the profit earned from the other products; and as a result, expected profit can be achieved in any situation. If a grocer sells both Halal soap and traditional soap, then customers of both kinds of soap will arrive in his shop. If the grocer keeps only general or traditional soaps, the customers of Halal soap will go to another shop to buy Halal soap and the total sales of the grocer will decrease. Sales of some products rise or fall due to the differences in weather or season also. As an example, the demand for winter wears increases only in the winter season. So, the sale of winter wears increases in that season. If a dress seller sells both summer and winter wear in his shop, then his profit earning will not be hampered by the rise and fall of demand for the products in different seasons. If in a book stall only textbooks are sold and if in another shop textbooks, story books, religious books, and different instructive books are sold, then it appears that maximum customers will prefer the second stall even to buy textbooks. Because they can purchase different types of necessary books from a single shop at a time. Besides, if the book seller sells only textbooks, then the sale may increase at the beginning of the year but at other times of the year, these sales may decrease abruptly. This principle of risk distribution through diversification can be applied in fund collection. In the case of fund collection, priority is given to fund collection from different sources.
Functions of Financial Manager
The financial manager deals with two types of decisions:
1. Income or Finance Decision
2. Expenditure or Investment Decision
Income or Financing Decision
Income decision mainly means the process of fund collection. The scope of this decision covers selection of the alternative sources of funds and taking financial plans by analyzing the advantages and disadvantages of these sources. Generally, to bear the current expenses fund is collected from short-term sources, and to bear the fixed expenses fund is collected from long-term sources. For the purpose of fund collection, it is collected through own capital and arranging loans from different sources. Besides, large companies may gather capital by selling shares. Shareholders are the real owners of a company. The portion of capital which an organization collects through loans increases the liability of the organization; again ownership right is established on the basis of the amount of capital collected through the owners’ fund. Thus, an institution becomes successful to create a balance between the liability of the loan and the rights of the owners through a right finance decision.
Expenditure or Investment Decision
The machine purchasing decision is an investment decision for a tailoring shop. In the case of a grocery shop, the decision for furniture purchasing or refrigerator purchasing is also an investment decision. For a production organization, production machines purchase or factory construction is also this type of decision. Through this decision, a plan of the expected inflow and outflow of funds has to be calculated. For example, a production organization decides to buy machines only when the selling of the machine-made products is greater than before and if thus profitability and inflow of funds are increased and if the total inflow of funds is greater than the purchase price of the machine.
That means, if it seems that the machines can be utilized for 10 years, then, for the purpose of investment decision, a comparison has to be made with the 10 years inflow of funds from sale proceeds for adding the new machines and the purchase price of these machines. So, it is possible to find out the 10 years cash flow from selling only by considering the product price in 10 years and the volume of sales. Production and other expenses are deducted from the sales earnings to measure the profit from the cash flow.
The investment decision is very tough for an organization because measuring the amount of selling in the future and determining the selling price is a very difficult task.
Other Decisions
Above two decisions are very important for financial managers. Besides, financial managers have to take some other decisions, such as:
a) Purchase of how much amount of raw materials is suitable and from which sources this fund can be collected – this type of decision is called a current investment decision.
b) How much amount of cash reserve should be kept for daily expenses is another important decision too.
c) Dues payment for the sources of funds is another decision.
If the fund is collected through a bank loan and other loans like- bonds, debenture, etc., then payment of a certain amount of interest at the right time is an important responsibility for the financial manager. In the same way, if a fund is collected through selling shares, then earning profit at the expected rate and distributing dividends is another important thing to be considered by the financial manager.
Evolution of Finance
After the Industrial Revolution of the 17th century, production technique becomes more complex and the production process attains its excellence through specialized and divided processes. To sustain in the market competition, finance-related concept and their use become essential. With the expansion of Accounting, in the 18th century, Finance was involved mainly in the evaluation and analysis of financial statements. With the development of the classical trend of microeconomics, finance was also involved in the own and specialized economics of business at the end of the 19th century. The trends of this financial evolution give us a meaningful idea about the nature and scope of finance.
Traditionally, financial managers’ main responsibility was account maintenance and making a future plan of action by analyzing it. Besides, report preparation to reflect the actual condition of the business and liquid fund management to build the business capacity of payment of the dues at the right time, are also added to the evolutionary process of finance. But with the expansion of civilization, the scope and technological development have changed the responsibilities of financial managers. The evolution of finance that happened in the last century in the USA, the main exercising field of finance, is later known as the trend of Evolution of Finance throughout the whole world. According to that, the stages of financial evolution can be present in the following way:
a) Pre-1930 Decade: This time a trend of unification began among the companies of the USA. Financial managers had to identify a framework about which company should be unified with which one, by examining the financial statements of the companies.
They took the responsibility of huge amount financing and of preparing financial statements for this unification.
b) 1930’s: The tendency of unification did not get success in the USA. Many of the companies unified in the past decade turned into bankrupt in the next decade. Moreover, high depression started in the USA. Many profitable companies also fell into a great loss. In that situation, how these losing companies can be reorganized to protect them from bankruptcy was a special responsibility of the financial managers. From that time, fund collection through share selling was started.
c) 1940’s: The necessity of liquidity was the main concentration at this time. Finance did that responsibility by ensuring well-planned cash flow by making a budget for cash flow.
e) 1950s: In this decade, finance was involved in evaluating the most suitable investment project by using different mathematical analyses. The main activity of finance then turned to profit maximization by increasing sales and decreasing expenditures through suitable long-term investments based on long-acting forecasting. This trend is considered the traditional trend of finance.
f) 1960’s: Modern finance started its journey from this time. Finance started giving priority to the capital market. Shareholders are the owners of a company, so maximization of the shareholders’ property or the market price of shares became the main objective of finance at this time. To achieve this objective, different activities relating to financial analysis were started. The concept of risk in finance makes us understand that risk increases with the increase in profit. So profit making may not be desirable all the time.
g) 1970’s: Era of computerized activities started in this decade. This not only changed production techniques but also brought changes in business finance. Finance is now Mathematics-based. Most of financial decisions are mainly based on complex mathematical calculations, and the tendency of making these calculations very effectively in computers got special popularity. For example, the concept of risk is now measured and managed more correctly. Traditional trends of capital structure are also more complex and mathematical. Among the scholars who deserve mention for enriching business finance with different theoretical analyses were Harry Markowitz, Murton Miller, and Modigliani. After that, in 1990’s these scholars got Nobel Prize as a reward for their contribution to the development of finance through mathematical analyses.
h) 1980’s: For the expansion of business and sustaining in the competitive market system, finance evolves in a new outlook by changing its previous roles. Efficient distribution of capital among alternative projects of the company and calculation & analysis of income of these projects was the main activity of finance.
i) The 1990s and the Beginning of Modern Finance: World Trade Organization revealed itself in this decade. Barriers to export and import started to decrease worldwide. This time finance achieved internationality. On one hand, investment decisions of finance consider where in the world production and selling of which product could achieve profit; on the other hand, the scope of finance also includes in its consideration which capital market of the world is of what type and from which sources fund collection will be profitable. As a result, finance is an applied field of solution in the financial management of a business organization which has developed in combination with accountancy, economics, and some other financial subjects.
