BCom Notes Part II Banking and Finance Business Finance
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Business Finance
Discuss the principles of financing. OR
State the importance and sources of short-term finance.
Introduction
Finance is required for business for the purpose of production and distribution of goods and services. No business, big or small can be run without finance. It is the life blood of business organizations. Money is needed to start the business. It is required to keep the business going and to expand the business. For production of goods and services we need material, machines, space, energy and technical know-how. For all these things we require finance. Finance is also needed for getting the goods from producer to consumer. The wholesaler and retailers need money for buying goods from different sources. Even consumer wants money to meet his requirements.
In modern large scale business with complex methods of production and distribution finance is used for various purposes. It is necessary for buying fixed assets such as, building, machinery, raw materials, labor and other expenses to convert the raw material into finished goods. It is also needed for meeting the other business operating expenses.
Finance may be defined as the provision of money at time it is needed. By business finance we mean finance needed by the business in different situations.
According to George Terry “Finance consists of providing and utilizing the money, capital rights, credit and funds of any kind which are employed in the operation of an enterprise.” So business finance means investing borrowing and spending of money in proper manner for the operation of business. Importance of finance cannot be ignored for the success of business. No business can run smoothly without the finance. There is always a need of sufficient amount of capital to achieve the desired results from the business operation.
In olden days not much finance was needed owing to the limited and simple nature of production and distribution of goods. Today the modern business operation became more complex due to specialization, division of labor and mechanization to produce goods at large scale. Goods are now produced in anticipation of demand. This has increased the importance of finance in the modern business.
Principals of Financing
Generally, business finance is obtained by two means. Firstly, the owner of business himself introduces capital to form a business, Secondly, finance is obtained through borrowing from the people outside the organization who provide finance on the basis of the principals of safety, profitability and liquidity. These principals are described below:
1. Principal of Profitability
An investor must employ funds in useful and profitable channels. He must think many times that money invested in a business should not become bad or uncollectable. He should not lend to a borrower with whom remuneration may be much, but also equally risky. On the other hand lender should prefer a borrower who is offering a higher rate of interest or profit on comparatively lesser risk.
2. Principal of Safety
The money which will be employed must be secured. Therefore, an investor must be very careful and ensure that his money is in safe hands where the risk of losses does not exist. He must ensure that the borrower is a person of character and will repay the money borrowed, including the profit or interest thereon. He must also see the capacity of borrower to repay the money borrowed. He must also consider whether amount invested for is reasonable in relation to the borrower’s own investment.
3. Principle of Easy Recovery
An investor must consider the possibility of easy recovery of funds invested in a business. He always invest money where he is assured of the immediate recovery. Investment in company shares and loans from banks and financial institutions are the examples of investment on the basis of this principle.
Types of Finance
On the basis of the purpose for which capital is required, finance may be classified into long term finance and short term finance.
Long Term Finance
The long term finance refers to the amount required for acquiring fixed assets like machinery, land, building, furniture and equipment etc. These assets remain in use for a long period and to acquire these long term finance is needed which is sunk in the business permanently or for a long term and is not available for immediate conversion into cash.
The amount of long term capital required by a concern depends on the nature and size of the business. Long term finance is utilized for establishing a new business or for expanding an existing business and to replace the old fixed assets by new assets or to acquire the benefits of new inventions, methods and technologies. Long term capital is invested for ten or more years.
Short Term Finance
It is required for day to day working of the business. It is required for the purchase of raw materials and for the payment of manufacturing, establishment, selling and distribution expenses. It is also required for holding convertible assets like stock of merchandise, receivables, and cash etc. In the course of business these assets are used again and again for the earning of profit. The finance required for this purpose is invested for a shorter period is known as short term finance or working capital. It represents the total investment in current assets such as cash, stock, receivables etc., minus current liabilities.
Medium Term Finance
Some economists give another classification if finance as “Medium Term Finance”. According to them finance required for the duration range from one year to ten years may be termed as Medium Term Finance.
Sources of Long Term Finance
The Long Term Finance must be basically provided by the owners of the concern since it is the amount which is permanently sunk in the business. To acquire fixed assets of the business long term finance can be divided into two parts:
1. Corporate Financing
In a company, the long term finance is raised by issue of shares. Additional fixed capital required when the business expands, is raised by means of long-term borrowings, such as the issuance of debenture, floatation of mudarba, accepting public deposits, borrowing from bank and other financial institutions and ploughing back of profits.
2. Non-Corporate Financing
This financing refers to the sole proprietorship and partnership, etc. In sole proprietorship business, long term finance is provided by the sole trader himself. In and partners may also acquire long term loan from their friends and relatives.
Sources of Short Term Finance
Such finance is required for acquiring the current assets of business and meeting the operating expenses of business. A business concern must have sufficient funds to carry on its current operations. The sources from which short term finance or working capital is derived are of utmost importance. For short term business needs are financed either out of internal sources or external borrowings. The extent to which external sources can be relied upon depends on various factors such as stability of the profit of the concern, its goodwill and credit standing in the market, the amount of cash readily available at any time, etc. Following are the main sources of short term capital.
Internal Sources
The initial working capital or short term capital is financed by the proprietorship of the business concern. Emergency requirements must be financed from internal sources, i.e., by utilization of the reserve funds built up by the concern.
External Sources
1. Trade Credit
It is a common practice of business community that they allow credit facilities to each other on open account for shorter periods ranging from 10 days to 90 days. In accounting it terms “trade creditors” or “accounts receivables” indicate sellers and buyers respectively.
Trade credit help in maintaining the flow of business smoothly. The manufacturer buys raw materials and many services on credit terms and sells the finished goods to wholesalers on credit. The wholesaler sells the merchandise to retailers on open account and the retailers to the same for their customers i.e., the consumers.
2. Commercial Banks
Commercial Banks offer short-term loans and advances to business concern during busy seasons. Banks also provide credit facilities by discounting Bill of exchange and granting overdraft.
3. Commercial Credit House
The concerns allow short term loans or credit on the basis of pledge or mortgage or property of needy business concerns.
4. Public Deposits
Sometimes companies arrange short term finance by inviting public to deposit their savings with them. They usually offer a rate of interest higher than the bank rate.
5. Private Loans
Generally to meet emergency requirements sole proprietors and partnerships obtain short term finance from their friends and relatives.
6. Financial Institutions
In certain situations financial corporations and development banks also provide short term credit or loans to industrial and commercial concerns Agricultural Development Bank, Industrial Development Bank, Small Industries Corporations are the examples of such financial institutions.
7. Loan by Partners
Partnership firms may obtain loans from their partners to meet the short term needs.
8. Loans from Directors
Some companies have provisions for obtaining loans from directors for short term financial requirements.
9. Government Loans
In some special situations government also provide short term loans to traders. In some cases only certain types of small business concerns, unable to secure the needed loans through private channels are provided financial help by the government.
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