The Importance of Finance in Business
Business finance is the art and science of managing your company's money. The role of finance in business is also to make sure there are enough funds to operate and that you're spending and investing wisely. The importance of business finance lies in its capacity to keep a business operating smoothly without running out of cash while also securing funds for longer-term investments. Finance relies on accounting, but while accounting is mainly descriptive, finance is active, using accounting information to manifest tangible results.
Businesses run on money, and business finance guides you to make shrewd and prudent decisions about cash flow and longer-term funding strategies. As you develop skills and strategies for using the funds you have and for accessing additional capital when needed, you'll improve your company's profitability and increase your potential for leveraging new opportunities.
The way business finance functions in an organization depends on management accounting reports. These documents should be current and accurate enough for your finance department to find them relevant and useful. There are three reports you should be looking at: the profit and loss statement, balance sheet and cash flow statement.
Your profit and loss report, or income statement, provides information about how much your company has earned or lost during the statement's period. Net profit (or loss) is calculated by subtracting total expenditures such as rent, materials and payroll from total revenue, which is also broken down by categories such as wholesale and retail.
A profit and loss statement is relevant to business finance because it shows whether your company can reasonably handle new expenses, such as investments in equipment or property. However, just because your business shows a net profit on its income statement doesn't mean you'll have the cash you need to pay off loans or buy new equipment. Some outgoing expenditures, such as payments on loan principal, use up available cash without appearing on your profit and loss as expenses.
Despite these discrepancies, if your income statement shows a trend toward profitability over time, you'll have greater potential for successfully paying off debt than if your income statement shows that your company has consistently lost money.
Your balance sheet provides information about how much you own and how much you owe. It is a snapshot of your overall financial picture at a moment in time. Balance sheet figures are useful for business finance because they show whether your company's level of debt is sustainable or whether you owe too much already, and it would be more advantageous for you to hold back on a major purchase you're considering.
By summarizing your assets and liabilities, a balance sheet can also give you a picture of the fluidity of your assets. Money in bank accounts is useful and available, while money tied up in inventory or equipment cannot be easily accessed.
A pro forma cash flow statement shows your anticipated incoming capital and outgoing expenditures over a period of time, such as a year, broken down month by month. While a profit and loss statement shows your earnings, which may show some discrepancies from your actual cash on hand because of accounting conventions, a cash flow statement specifically addresses the availability or shortage of cash.
This makes it especially relevant and useful to your finance department. However, a cash flow pro forma is still a projection. It will almost never exactly correspond with your actual financial picture. Its speculative nature makes it somewhat less useful for making financing decisions.
In a perfect world, your business would always have enough money coming in from sales of goods and services to pay for daily operations. In the real world, most businesses need some kind of funding to cover short-term expenses, which don't always correspond with incoming revenue streams. Your business may be seasonal, earning enough money over a couple of months to cover long periods during the rest of the year when you operate at a loss. Or your business may be very busy late in the month or late in the week, but you still need to make ends meet during the slower times.
Financing for working capital is easier to obtain than financing for major purchases and investments. Many banks offer unsecured credit cards and business credit lines. You can use these options to cover business expenses without staking personal collateral or filling out long loan applications requiring extensive documentation. However, interest rates for unsecured financing options tend to be considerably higher than for business-lending products that are harder to obtain, such as secured term loans. Because of these high interest rates on credit cards and credit lines, it's prudent to use these loan products only for short-term needs and to pay off balances as soon as possible.
Business finance is important when evaluating working capital financing because it gives you the tools and information to assess how much money you need and the best way to get it. If your company operates with a monthly cycle where it accrues most of its expenses early in the month and earns most of its income later in the month, a high-interest credit card isn't such a bad option. You'll pay the money back quickly, so you won't be seriously hurt by the interest rate.
If your business operates at a loss from January until Thanksgiving and then earns enough in December to offset these losses, it's worth doing extra research and paperwork to secure a lower-interest credit option because you'll be paying interest for a longer period of time.
When your business makes purchases of equipment or property with lasting value, finance comes into play as you evaluate whether you're ready for the expense and then find the best way to pay for it. It is common for long-term capital investments to require loans, so you'll need to consider interest expense and principal payments. Your business needs to earn enough to cover these upcoming expenditures.
A cash flow pro forma is an indispensable tool for forecasting and planning. You can plug in the amounts of anticipated principal and interest amounts and also tinker with other variables to find ways of making these extra payments. For example, if you're investing in a piece of equipment that will reduce labor costs, your pro forma will show how far these savings in labor will go toward meeting the payments on the equipment.
When you're making capital investment purchases, you'll also use business finance to weigh the pros and cons of different repayment options. Let's say you have a choice between a lower-interest loan with a high monthly payment and a quick repayment period versus a higher-interest option with lower monthly payments over a longer period of time. Of course, a lower-interest option is the best option, provided you have the cash flow to pay for it. But if your cash flow is tight and the equipment upgrade will save you enough money to cover some added interest, you may actually decide that the option with higher interest and a lower monthly payment is better. Lower payments help cash flow, and good cash flow puts you in a position to take advantage of opportunities.
There is no set, reliable formula for evaluating all the costs and benefits of a long-term financing option. However, if you consider all the ways that a purchase will affect your income and expenses, you'll probably make a better decision than if you focus on the interest rate alone.
Another variable that will affect the long-term costs and benefits of a purchase is the value of the money you spend and the way it changes due to inflation. When you make a loan payment in the future, you'll use capital that is worth less than the capital you borrowed because inflation decreases the value of money over time. Accountants and finance professionals use a formula called "return on investment" to calculate all of the quantifiable benefits that an investment will bring in over time and then compare these benefits with the total cost.
Finance decisions for major capital improvements should also take depreciation into account. When you make a large investment, such as a van, computer or building, your business must follow a set of tax conventions for reporting the purchase. The way you log this expense into your bookkeeping system has ramifications for your income and cash flow. Instead of being able to deduct the entire cost of the major asset in the year you bought it, you are required to declare a period of time for that asset's useful life and then deduct a percentage of its initial cost during each subsequent year.
The IRS stipulates specific depreciation periods for certain types of equipment, such as vehicles and computers. Other investments, such as lease hold improvements, come with more leeway. The depreciation period you choose affects your tax liability. The more quickly you can depreciate an item, the more of its cost you can deduct each year, decreasing the taxable income that you report to the IRS. It's prudent to speak to a tax professional before making decisions about how to depreciate an especially large purchase, such as a building.
The term "finance" is used as a noun describing the process of managing your company's money, but it is also used as a verb meaning to secure capital from an outside source through a loan or investment. Despite this association with borrowing, you can also use business finance to manage the funds you have available from regular business activities, such as sales of products or services or rent on property you own.
These retained earnings are an appealing source of operating or investment capital because you don't have to pay interest on them. You also don't have to convince a banker or investor that your project is worthwhile, and you don't have to do all the paperwork required for a loan application.
If you rely exclusively on retained earnings for short-term cash flow and longer-term investments, you may lose out on opportunities you could have leveraged if you'd had more money available. You may get a lucrative order that requires more of a capital outlay than you can make with your available cash. The cost of losing the business can be higher than the interest you would have paid if you borrowed the money. Similarly, if you own a retail location and you're keeping strictly to a cash budget, you may be unable to buy enough inventory to offer enough of a selection to lure potential customers.
A finance strategy of working primarily or strictly with capital from retained earnings is a prudent approach, but it can also make you overly cautious. You may hesitate to buy a piece of equipment you need because you don't have the cash on hand, but you would have saved more in labor over time than you would have spent on the equipment. It's a good idea to use retained earnings whenever you can do so comfortably, but line up backup sources of financing so your business doesn't suffer on the occasions when your available capital just isn't enough to make a smart move or to recover from an emergency.