The Primary Areas of Business Finance
Corporate Finance, Investments, Risk Management and Financial Markets
Business finance is one of the functional areas of business, along with marketing, management, human resources, information technology, and production management. It is one of the most important functional areas because finance is essentially the lifeblood of businesses. The finance function, which is related to accounting, is responsible for pumping money to the other operational areas of the business.
Money is allocated for daily operations and special projects, in appropriate amounts, by the finance function. The goal of a business firm should be to allocate money to the functional areas of the company in a manner that maximizes the wealth of the owners. That is the responsibility of business finance.
What Is Business Finance?
Business finance is one of the most important areas of a company since money is the driving force of a business. Accounting is responsible for taking the raw financial data generated by a business firm and developing the financial statements for the business owner. Finance, in turn, steps in to read and analyze the financial statements and supporting documentation.
The finance function uses financial statements to plan for, obtain, and manage the business's money.
The business finance function is responsible for the management of the company's money, the process of obtaining funds for the company, and the management of how much risk the company should take in order to return an adequate amount of money to the owner(s).
In a small business, business owners and managers should have a basic understanding of business finance even if they outsource certain areas of their financial operations. For example, a small business may outsource at least part of its bookkeeping and accounting. Becoming familiar with the basics of business finance can give an owner some additional tools to help understand the financial complexities of business ownership.
The three major areas of business finance are corporate finance, investments and financial markets, and risk management.
Corporate finance is a broad description of the planning, management, and control of a company's money. Corporate finance includes working capital management, financial statement analysis, cash budgeting, capital budgeting, and more. In a small business, the owner/manager conducts the daily financial operations of the company. In larger businesses, daily finance decisions may be made by the owner/manager, along with a finance committee. Larger financial transactions may need to be approved by the Board of Directors of the firm.
Corporate finance includes the management of the following areas of the finance function:
- Working Capital Management
- Cash Budgeting
- Financial Analysis
- Financial Statement Development
- Capital Budgeting
- Dividend Policy
In a small business, the owner uses this financial information to keep track of the account balances of the cost, revenue, and expenses found on the income statement, and the information from the statement of cash flows.
This information is used to create measurements to gauge the company's financial performance.
Performance is measured by developing metrics such as the current ratio—the ability to pay your financial obligations on time.
The balance sheet, income statement, and cash flows statements are generated for accounting purposes. These statements are required for companies that are publicly traded—they have issued stocks to investors on a public trading market—but they can be used to analyze private businesses of all sizes as well.
Financial analysis is usually used as a method of determining a company's liquidity, solvency, and investment potential. It can also be a vital tool for a business to use internally to view the financial performances of different departments, operations, or processes.
Investments and the Financial Markets
The second area of business finance is investments or the investment decision, which also involves the financial markets and financial institutions. This type of marketplace and company, respectively, makes easy transfer of money possible when investments are made.
The investments decision in a business firm is the process of investing in assets that will yield a return at least as great as the firm has to pay to obtain financing.
In order to understand investments, we have to understand the financial markets in which they are traded along with our financial institutions. Financial markets, from an economic point of view, help facilitate the transfer of funds between savers of funds and users of funds. Savers are usually households, while users are generally the government and the business sector.
Here are some examples of investments that a small business may make.
Businesses can invest in the stocks, or equity securities, of other businesses. The return may include dividends and capital gains. The business making the investment owns a piece of the company in the case of stock investing.
Businesses can invest in the bonds, or debt securities, issued by other companies. The return will include the return of the principal at maturity and interest payments. The business making the investment owns at least a portion of the company's debt.
These are short-term, liquid investments, usually made at a bank or other financial institution, that have a maturity of one year or less. The return is usually in the form of interest.
Commodities are products with relatively volatile price swings, like pork bellies or coffee. Their prices rise and fall rapidly. For example, a trader would agree to purchase coffee when it is brought to market and at a previously agreed-upon price. Commodities are risky investments—not always suited to small business—since the price can rise or fall and create heavy losses.
Derivatives are products from adjacent markets. The trade is conducted in the form of a contract between two parties, and the value of the derivative is based on the value of the original investment. This agreement creates a benefit for both parties. Derivatives raise and lower risk depending on the terms agreed upon by the buyer and seller.
Companies can also invest in themselves by expanding their capacity and purchasing land, buildings, or equipment.
Financial institutions such as banks, investment companies, mortgage banks, credit unions, and brokerages work within the financial markets. These financial institutions generally act as intermediaries that help make transfers of funds between businesses and savers (working as a broker or agent for the trade) easier.
Within business firms, risk management is the process of the identification, analysis, and mitigation of risks facing your company, including your investments. A financial, or company, manager has to identify the risks facing the company and then make an attempt to quantify them. The risks that a business firm takes determines its tolerance for risk and its potential to make a return. The return on a company's investments, or capital projects, must at least equal the level of risk associated with the investment or project. If not, the company will lose money. If the return is more than the assessment of quantifiable risk on a project or investment, the firm will make money.
An example of a risk a company might face is that from weather. If a company is located along the Florida coast, it is taking the risk of destruction due to a hurricane. In order to mitigate or offset that risk, the company will want to invest in a good hurricane insurance policy.
If a company invests in the stock of another company, there is associated risk that the other company will not make money or will even fail. In this case, the return from that investment has to be sufficiently high to offset that risk.