Companies need cash flow to conduct their business activities. All business activities depend in some way on the availability of cash and the flow of funds. Money is the lifeblood of all organizations small and large, profit and nonprofit.
Business finance is the science and art of managing money. Generally speaking, it deals with the administering, disbursing, controlling, raising and planning of funds used in operating a business.
Components of Finance
Business finance focuses on ways to manage funds effectively in a business. It uses various components of finance to allocate funds, arrange sources of debt and capital, evaluate investments, keep score of profits and monitor the financial health of the business. The methods used in business finance, or financial management, have the primary goal of increasing shareholder value or adding wealth to the organization.
Financial management is a part of functional management of departments such as production, accounting, sales, marketing, engineering and personnel. It uses different elements of finance to manage and control the activities of these areas.
Principles of Economics
Business finance uses the principles of macro and microeconomics. For example, it uses equations for the time value of money to evaluate viability of investments. Another example is using calculations for economic order quantity to manage inventory levels.
Mathematical and statistical models aid in decision making for setting dividend policies, calculating the cost of capital and determining optimal capital structures.
Monitoring Business Performance
Business finance uses accounting tools to monitor the financial health of a business. These are ratios and data taken from the company's financial statements that focus on profitability, liquidity and leverage. A few examples of these ratios are:
Profitability: Gross profit margin, earnings before interest and taxes and net profit margin
Liquidity: Current ratio, quick ratio, working capital, accounts receivable collection periods and inventory turnover
Leverage: Debt-to-equity ratio, total debt to equity, debt-to-total-assets ratio
Managing Working Capital and Controlling Production
Working capital management focuses on a company's short-term assets and liability: cash, accounts receivable, inventory and current liabilities.
Production managers use elements of business finance to monitor and control their operations. Finance gets involved in production because funds are used to purchase raw materials, pay wages, buy machinery and purchase operating supplies. Finance managers set up standard operating costs and production budgets to control and measure performance.
Allocating Manpower and Selecting Investments
Providing funds for the manpower needed in all departments is a business finance function for human resources. Finance managers evaluate labor requests from department heads to allocate funds and set up budgets for wages, salaries, fringe benefits, bonuses and retirement plans.
Management is constantly faced with making decisions about new investments. Will these investments be viable and return a profit? Will they produce an adequate return on the capital invested? Business finance has ways to answer these questions.
Managers use capital budgeting techniques to identify possible investment projects, make cash-flow projections, compare expected performance of different projects and decide which investments will be approved and included in the budget.
Determining Capital Structure
A business must have an appropriate capital structure with an optimal balance of debt and equity capital. Business finance principles provide guidelines for a reasonable level of debt compared to the amount of equity.
Businesses with stable cash flows, such as utilities, can support higher amounts of debt, whereas manufacturing companies must have lower debt/equity ratios because sales and operating costs can be more volatile.
All aspects of a business use various components of finance to control the activities and operations. It could be securing funds for a new investment or setting budgets for production and marketing.
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