Business finance is the money you need to establish and run your business, which includes modernizing or diversifying operations and expansion. The more successfully you manage your money, the higher your odds are for profitability. The term "business finance" includes the ways in which a company obtains and uses money, usually in reference to loans. And in the broader context, business finance is about strategies for earning, saving and investing revenue.
Business Finance Meaning
Business finance includes the information contained in financial documents such as profit and loss statements, balance sheets and cash flow statements. It also covers strategies that businesses typically use to manage their money, such as leveraging future rather than present value. Armed with this knowledge about how money flows and grows, you will have the tools to make strategic decisions for managing your business's finances and take advantage of opportunities.
For example, you may have a choice between two loan products, one of which has a higher interest rate and flexible terms, while the other has a lower interest rate but rigid terms. Understanding business finance gives you the know-how to evaluate how much you will likely spend repaying either of these loans in longer or shorter repayment times. You'll need to review your circumstances in-depth and all the costs associated with the product you're planning to develop. If you are reasonably certain of your product's success and believe you can take it to market quickly, the lower interest loan with rigid terms is probably your best bet. If the development process will be slow and there are multiple wildcards, you may be better off with the higher interest loan. Its more flexible terms will allow you extra leeway for a research and development process to perfect the product, even if you end up paying extra for financing.
Types of Business Finance
There are two main types of business finance, short-term and long-term. And your business needs to set up both short-term and long-term finance strategies to operate. Short-term finance takes the form of working capital, or the cash flow you need to cover day-to-day expenses such as purchasing materials, payroll, rent, utilities and loans. Working capital can come from day-to-day operations, such as payments from customers who have purchased your products or services. But if your business volume fluctuates or if you need to buy in volume periodically, you'll likely need some short-term financing as well. Business credit cards are a common form of short-term business financing, as are revolving lines of credit. Interest rates on these options may be relatively high compared to long-term loans, but if you pay your credit card bill in full each month and pay down your credit line quickly, you can avoid excessive finance charges.
Fixed capital investments require longer-term finance solutions. These capital investments go towards big ticket items that your company needs for its day-to-day operations. For example, commercial property and factory buildings for a manufacturing operation are fixed capital investments, as are vehicles, expensive equipment and machinery. Capital investments are typically financed by long-term loans, which usually have lower interest rates than short-term options such as credit cards and credit lines. But long-term loans also usually require some form of collateral, which could be personal assets. If you cannot pay back your loan, your lender can recoup his money by selling your collateral. When making fixed capital investments, it's prudent to consider not only the interest you'll pay on the funds you borrow but also the future value of your investment. Additionally, the money you'll use to pay back your loan will be worth less than its current value due to inflation.
Why You Need Business Finance
Every business must make short-and-long-term decisions about how it spends and invests its money. It's impossible to predict trends and product demand with complete accuracy or to foresee long-term opportunities and threats. But a good understanding of financial strategies and financing options can help you make sound choices. If you understand the sources of capital available to you and the nuances of using a business line of credit versus a term loan, for example, you'll be able to make an informed decision about which financial product is best for your current situation. Keeping your long-term objectives in mind, you can leverage the financing options available if you have a clear vision and financial plan for how you want your company to grow. You should also have a realistic expectation of how long it will take to achieve your financial goals.
How to Manage Business Finance
It is a common cliche that small business owners are risk takers, but successful entrepreneurs manage the risks they take with a healthy dose of business finance knowledge. To manage business finance:
- Keep accurate and up-to-date books, so you know what is going on in your business at any given time. A clean set of books gives you the earnings, expenditures and cash flow information you need to manage your business in the short-term and helps you set longer-term goals.
- Develop long-term goals so you can plan and save for large investments such as equipment, technology or human resources. Long-term strategic planning requires making short-term choices and taking small steps toward your bigger-picture objectives. Research the cost of the big ticket items your company will eventually need and chart a course for growth that keeps you on track for achieving your financial goals.
- Develop relationships with the bankers who manage your accounts. A banker who knows your business and has watched it evolve will be personally invested in helping you secure the financing you need and helping your company succeed.
Business Finance and Financial Statements
Successful business finance starts with the financial statements that track and organize your company's financial activity. Accurate financial statements will provide information about how much financing your business needs to achieve its goals, and how much you'll need to earn to pay off the debt. You'll need financial statements when you approach lenders. Because bankers and investors don't have access to your day-to-day operations, they rely on accurate financial statements such as your profit and loss statement, balance sheet and cash flow statements for the critical financial information they need to assess your business's financial health and risks.
- Profit and loss: The profit and loss or income statement summarizes your financial activity over a period such as a month, a quarter or a year. It shows how much your company has earned in revenue, and how much it has spent to generate this revenue. It breaks down your expenditures into fixed expenses such as rent, which doesn't change as your business volume increases, and variable expenses such as materials and payroll, which correlate with the amount of business you do. A profit and loss statement shows not only how much profit your business has netted during the period it covers, but also your percentages and margins, or potential for profitability as your volume increases. For example, if your manufacturing company spends 60 percent of its revenue on materials and payroll, it's more likely to be financially successful than if it spends 80 percent, even if your current volume is small.
- Balance sheet: Your balance sheet shows your company's net worth by listing everything you own (assets) and everything you owe (liabilities). It is a snapshot of your financial situation at a particular moment in time, and it changes as you earn and spend money. Assets listed on a balance sheet include the cash you have in the bank and on hand, your accounts receivable or sums owed to you for business you've already transacted and your long-term assets such as equipment. Liabilities listed on a balance sheet include short-term debt such as accounts payable and long-term debt such as balances of term loans and mortgages. A close look at your balance sheet will also tell you whether your company is likely to need short-term financing. If most of your assets take the form of long-term investments and you have very little cash, you'll probably need to borrow some money soon unless you have substantial accounts receivable.
- Cash flow statement: Your cash flow statement is especially important for business finance because it shows how money is flowing in and out of your company. Cash flow is not the same as profit and loss because some sources of cash don't come from business income and some outgoing cash doesn't go towards deductible business expenses. For example, if you borrow money to cover operating expenses when business is slow, the sum you borrowed helps your cash flow even though you haven't earned it. Conversely, when you have to pay that money back, you'll make payments that affect your cash flow, although a loan payment isn't a deductible business expense that shows up on your profit and loss statement.
Pro Forma Financial Statements
Pro forma financial statements are projections or pictures of how you expect your finances to look at a particular point in the future.
- Pro forma profit and loss statement: A pro forma profit and loss statement shows how much you expect to be earning and spending in the future. The statement is important for business finance because it indicates whether your business model is viable enough to allow extra income for paying back your loans.
- Pro forma balance sheet: A pro forma balance sheet shows how you expect your profitability to play out over time or your expected net worth by listing your assets and liabilities. It is important for business finance because it shows whether your expected net worth will increase sustainably as a result of the money you plan to borrow and invest.
- Pro forma cash flow statement: A pro forma cash flow statement shows what funds you expect will come into and go out of your business during the period when you'll be paying off your loan. It is important for business finance because it shows month-by-month how you will use your available capital to both keep your business running and also make your loan payments.
Custom Approaches to Finance
Conventional financial statements are invaluable for obtaining necessary information about your overall financial situation. They are essential for obtaining outside funding and a prerequisite for most business loans. Your financial statements are proof that you are managing your company's finances responsibly. But you can also approach business finance in ways that are unique to your company's culture and circumstances. For example, if your business is organized as a worker-owned cooperative, you'll also need spreadsheets that show each member-owner's equity, and how this equity will translate into patronage payments that could affect company cash flow.
Further, you may have arrangements to barter with some suppliers and customers, and these arrangements may affect the ways your company earns and spends its cash. Whatever unique approach your business develops for managing its finances, it should be documented and tracked so you fully understand your financial picture and your prospects for the future.