The importance of Finance

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    Finance, a very important thing to keep in mind while studying business, is what we will be going through in this lecture. So guys, take out your notebooks or whatever you have to make a list of all the reasons a business might have for needing finance. You’ll probably come up with something like this: For buying new machinery, for raw materials and other fixed costs; you are right, but these are just some of the many uses of finance in a business. The uses may vary from starting up the business to paying the rent. In general however, we classify the uses in two main types. Capital Expenditure and Revenue expenditure . Money spent on fixed or long-term assets is called capital expenditure and that money spent on day-to day expenses is known as revenue expenditure.

    Cashflow is another very important term in finance. It is the cash inflows and the cash outflows over a period of time. Cash inflow as the phrase suggests is the way in which a cash enters a business be it the sale of goods or other non-business income. Cash outflows are the ways in cash exits or leaves a business be it the purchase of raw materials or the wages given to labour. Cash flow planning is necessary for any business to flourish, this means to anticipate or predict the cash inflows and outflows snd adjust the sources of finance accordingly.

     

     

     

    Sources Of Finance

    There are many sources of finance for a business, but to make them distinguishable and easy to remember, they have been grouped in three different categories.

    1. Short-Term Finance
    2. Medium-Term Finance
    3. Long Term Finance

     

    Short –Term Finance

    It is the finance which is needed by businesses for operations which take upto 5-6 months

    Over Drafts:

    Overdraft is a source of finance that allows the business to withdraw more than it has in its account. E.g if a company has to make replace some old furniture in its office which would take Rs. 55,000 and it has been facing loss due to which the money in its account is 47,000 Rs., it can still pay for the furniture by overdrawing from its account an amount of Rs 8,000( the extra amount). This has the considerable advantage that the business has to pay interest for only the extended amount. And also that overdraft rates turn out to be cheaper than loans. However, a business ought to have an account in the bank and an overdraft facility in order to benefit from the source of finance.

     

    Trade Credit:

    It is basically when a business buys a product from another business and pays for it later. This is common between wholesaler-retailer relationship. It is an almost interest free loan. But delaying too much to pay can leave a bad impression on the other business and this could prevent him from giving it again.

     

    Medium-Term Finance:

    Finance which is available for between three and ten years.

    Bank Loan:

    The most common form of medium ter finance is ‘LOAN’. All of you must be familiar with this term which involves taking a definite amount of money from a business only to pay it later in installments as well as the interest, to the bank.

    Hire Purchase:

    Hire Purchase allows a business to buy a fixed asset i.e machinery and pay for it in installments along with interests. Of course it is a lenient form of buying an otherwise expensive capital good however, the overall price of the machinery using this method is more expensive than if it is bought at its original-at-the-point price.

     

    Long Term Finance:

    This type of finance lasts for more than 10 years and is needed accordingly for much larger fucnctions, such as expanding a business, opening new outlets etc.

    Shares:

    Shares or equity finance is a very convenient way for PLCs to raise large amounts of money without having to pay any interests. This sort of finance is needed when large amounts of money need to be gathered. This has the disadvantage that if too much shares are sold e.g greater than 50%, the owner will lose ownership of the company.

    Debentures:

    These are certificates a business sells to people who invest money into it. This serves as a claim if those people want to take their money back. Debentures like shares are very convenient sources of long term finance.

     

    Now last comes the point of choosing the right type of finance option. In order to elucidate a point I would start off with an example. Sarah, a successful hotel owner, decides to expand her business by opening another outlet in another city, the project seems fruitful and thebudget has already been predicted, now all she needs is a proper type of finance. The first thing that must come into her mind is the 1) purpose and time period of he project( Opening another outlet is of course not a one-month project, rather it will require years0. 2) Amount needed. The amount will also not be mediocre, I mean it is not room she is building, it’s a whole new hotel which requires, architectural planning, construction, furnishing etc. which are bound to take huge amounts of money so, it is these two factors that help her arrive at the conclusion that she is going to need Long-term finance for this type of initiative.

    FAQ

    Q: 1A) Define the term Cash Flow.

    Ans. Cash flow is the flow of cash in and out of a business. This means that it is the cash inflows and the cash outflows of a businesss over a period of time.

    1. b) How can we determine the right type of finance for a project?

    Ans. Finance is the amount of money needed by a business for several reasons. In order to determint the right kind of finance, we need to only consider two factors.

    The length and purpose of that finance, is the first factor that must be bore in mind. Of course solving a temporary cash flow crisis requiring miniscule amounts of money would not require us to sell our company’sshares, but buying a very expensive machine which is to be used for a very long time would require us to sel our shares.

    Lastly, we need to bear in mind the amount needed, the larger the amount required the greater the source of finance be used. As simpleas that.

     

    Ok so bye I will catch u guys later, don’t forget to check out my next lecture. I will be waiting for you guys, bye.