Business, Global, Student Reporter

The Basics of Finance

Avatar photoHeon Jeong Yi

The different sources of finance

Source of FinanceDefinition & ExplanationBenefitsLimitations
    LoansAmounts of money borrowed from other financial institutions or banks for long-term and large business– Interest rates are lower than for bank overdrafts and set in advance
– Suitable for long-term investments
– Large amounts can borrow		– Interest is charged
– Loans will affect a company’s gearing ratio
– Collateral is needed
– The amount borrowed has to be repaid at the agreed date
    Personal SavingsThe amount of personal money a partner, shareholder or an owner of a business has at his disposal to do whatever he wants– No paperwork is required
– The money need not necessarily pay back to the owner on time
– The owner would not want collateral to lend money to the business		– Not an option for very large amounts of funds to be required
– If the owner demands the money back on short notice, it might cause cash flow problems for the business (informal agreement)
    Government GrantsA ‘gift’ of money given by the government to a small business, usually after an application process, to encourage types of businesses or entrepreneurs– No repayments
– Some charities may also give grants
– No interest to payback  		– Long and in-depth application process
– Only a small amount of capital is granted
– May be conditioned to meet attached to the award of the grant
      Retained profitsThe undistributed profits of a company– No interest payments are to be made on the usage of retained profits
– No costs are raising the finance, such as issuing costs for ordinary shares
– The company need not pay back since it is the organization’s savings  		– Not available for starting up businesses or for those businesses that have been making losses for a long period
– There may be opportunity costs involved  
    Bank OverdraftA short-term credit facility provided by banks for their current account holders– Ideal for short-term cash-flow deficits
– Interest pay only when overdrawn and on the exact amount needed
– No security is needed for a bank overdraft
– Easy and quick to arrange		– Limit the amount that can be overdrawn
– Difficult to calculate the cost of borrowings
– Only for short-term financing

Appropriate sources of finance for a business

Capital sources meet different types of requirements by having other characteristics. Choosing the right resources is an important consideration in starting a new business project. The big framework classifies into internal and external resources, and financial sources based on ownership and control can divide into owned and borrowed capital.

  • Internal sources

– Retained profits

– Sale of assets

– Reduction or controlling working capital Etc.

It refers to the capital created internally by a company, and by growing its own business without relying on external parties, there are no disadvantages in money and debt. No fixed bankruptcy and obligation risks arise.

  • External sources

– Debt or Debt from Banks

– Equity

– All others except Internal Sources

All capital other than the re-emergence of funds is defined as an external source and refers to capital generated outside the company.

  • Owned Capital

– Retained Earnings

– Convertible Debentures

– Equity

– Preference

– Venture Fund or Private Equity

Ownership capital refers mainly to money raised from the general public, and it is common to submit through the company’s promoter and issuance of new shares. Ownership is a preferred form of capital for companies in the early stages of business because they are free from the burden of installments or interest, such as borrowed capital, and the risk of bankruptcy is significantly low.

  • Borrowed Capital

– Commercial banks

– Financial institutions

– The public in case of debentures

Borrowing capital means funds raised externally on the premise of capital repayment and must pay at a regular fixed interest. The amount of borrowing is not large because borrowing or debt capital does not decrease ownership and control of the business itself and is mainly used for deduction purposes to reduce taxes. It serves as a lever for the entire company, providing a foundation for the company to expand in a short time.

The costs of different sources of finance

Short-term finance

– Including fees for cash flow finance and invoice factoring (2.5 to 3.5% of the base rate)
– Need to pay service fees based on business sales (0.5% to 3%)

(1) Bank overdraft

– Including maintenance fees, unused fees, annual contract fees, etc.
– Interest charged in case of default will be different.

(2) Business credit card
– Expensive fee, Interest charges are high.
– Within the deadline, needed only to pay a regular fee.

(3) Trade credit
– No direct cost
– It is necessary to pay indirect expenses (employment expenses, conditions to suppliers, product-related, etc.)
– Operating capital expenses incurred (if a business is in a negative operating capital situation)

  • Medium-term and long-term finance

(1) Bank loan
– Interest (Loan agreement, lower on other requests)
– Fees such as insurance premiums and contract fees may be applied.

(2) Rental fee
– Including capital costs and maintenance, rent/ installment payments, etc.
– Provides more flexibility than owning an asset
– Asset with a higher resale value has an advantage in interest rate.

(4) Major costs to consider when funding from friends or family
– Interest. (Only then)
– Accounting, management account.
– Fee for writing a regular agreement.
– Legal advisory fee

(5) Cost of listing on the stock market
– Fees (most of the direct cost of listing)
– Admission fee (based on the market capitalization of the company on the day of admission)
– Annual fee. (It’s already decided)

(6) Option premium
– Price of options sold on the exchange or claimed by the issuer.
– Internal value = (the difference between current market interest rates and future hit prices) + price volatility level + time value
– The option price is higher than the pure option value by providing a non-standard structured solution.

(7) Considerations when applying for subsidies
– The use of designated suppliers.
– Compliance expenses
– Expert advice

 (8) Trade loan
– The interest rate on the debt amount.
– Applies different fees depending on the borrower and type of loan.
– Agreement fee (subsidiary expenses and funding, business size and lease vary)

The importance of financial planning

Definition of financial planning

Financial planning is devising a company’s overall economic policy related to business investment, management, and necessary capital procurement. In other words, it refers to determining how much funds are needed for the project and making a budget.

Objectives of financial planning

  • Determining capital structure

It is necessary to consider the composition of capital, including short-term and long-term debt ratio and the ratio and relative type of capital required to conduct business.

  • Determining capital requirements

Two aspects of short-term and long-term requirements need to consider: long-term planning, promotional costs, current assets, and broken asset costs before making a decision.

  • A Finance manager

Financial managers should make the most of the minimum cost to maximize return on investment.

  • Financial Policies

The overall financial flow, i.e., financial policies related to cash loans and borrowings, should be established to proceed with an effective and efficient process.

The importance of financial planning

– It helps create programs that help companies grow, expand, and survive in the long run.

– It helps to grow while reducing business uncertainty. In other words, it helps ensure stability and profitability.

– It helps maintain and ensure a balanced and reasonable relationship between the inflow and outflow of funds, helping maintain stability in overall funding activities.

– It helps fund providers easily invest in companies that make and carry out financial plans.

– Funds prepared in advance through financial planning help cope with rapidly changing market uncertainties.

The impact of sources of finance on the financial statement

 Financial statements are written records to understand the overall management activities and financial performance, liquidity, and location of a company consisting of balance sheets, income statements, and cash flow statements audit for investment, financing, and taxes.

The balance sheet is a summary of a company’s assets. It provides an overview of the assets, liabilities of a company, and the capital of shareholders. It is a convenient means to summarize the relationship between assets currently owned by a company and debts to pay back.

Income statements usually measure corporate profits and expenses for one quarter or a year. Generally, a company’s net profit figure calculates by subtracting expenses from revenue.

Cash flow statements serve financial statement users with sources to measure and evaluate a company’s asset creation ability and cash flow, such as a company’s cashable asset creation capacity, debt repayment, operating expenses support, and fund investment.

Budgets in a business

Activity-Based Budgeting

Activity-based Budgeting is a method of setting a company’s sales target first, determining the cost of collaborating with each department or team needed to achieve the goal, and then selecting the cost of performing the activity.

  • Incremental Budgeting

Incremental Budgeting is the most appropriate budgeting model that can use when the cost factors or factors mainly used do not change yearly. The total budget is subtracting or adding the ratio to set this year’s budget after checking and collecting actual costs and figures for last year.

  • Value proposition budgeting

The value proposition budget aims to support everything set in the budget to create value for the business by eliminating unnecessary expenses as much as possible.

  • Zero-based Budgeting

Zero-based budgets start with the assumption that they have the strictest standards of all types of budgeting. All departments should begin with zero budgets. Automatic expenditure approval achieves never, and goals are set. So, the expenditures are not made other than what is essential for a company’s operations, mainly profitable operations. Because such Budgeting is time-consuming, it uses in emergencies such as corporate financial restructuring and major economic downturns. It uses to cope with discretionary costs.

The calculation of unit costs

Cost per unit

Cost per unit uses by companies that produce and sell products (small stores and national companies), showing how much money spend on production per product sold. These figures can find mainly in the company’s financial statements.

How to calculate cost per unit

  •  Fixed cost determination

Fixed costs are the costs that do not depend on unit production and remain the same over time, such as business insurance, annual employee salary, welfare performance, office rent, and property tax. However, factors may vary from company to company.

The step cost is the case where additional space needs to lease so that manufacturers can process orders as the production demand increases, and a new fixed cost needs to set in consideration of this.

  •  Identifying variable costs

Variable costs differ depending on the number of units produced by employees’ hourly wages, product material costs, advertising costs, utility bills, and credit card fees. These are costs that can be changed regularly. The period of change can occur daily, monthly, quarterly, annual, etc., and is the total material costs required for product manufacturing and production.

  • Identifying production units

When calculating the cost per unit, all units of measurement must be kept constant, and the final figure required is the number of units produced. Fixed and variable expenses should also maintain in units over time, the number of units may be units produced quarterly or periodically, or the price per unit may calculate according to the number of units produced over time.

  • Calculation of unit cost

The cost per unit is calculated by summing the cost per unit and the variable cost and dividing the total result by the number of units produced.

Cost per unit = (total fixed cost + total variable cost) / total unit of production

The cost per unit represents the minimum value of selling the product, that is, the selling price before the break-even point. Generally, the cost per unit is higher than the cost of producing a good, and companies can set the most appropriate price per unit through market analysis. Total cost reduction per unit can improve through continuous evaluation of fixed and variable costs, which link to the high profit.

Formats of financial statements

  • Balance sheet

The balance sheet or financial position sheet summarizes a company’s financial balance based on the balance sheet equation. It outlines assets, liabilities, and capital, such as corporations, privately owned business partnerships, and private limited companies. To check the financial status at a specific period and time is possible. It is one of the four important financial statements required for companies and businesses.

On the balance sheet, the left divides into assets and the right divides into finance, and assets divide into two aspects: owned capital and debt. The asset expresses in the order of liquidity, and the difference between debt and asset can see as a company’s net assets or capital.

  • Income statement

The income statement has information that can determine a company’s financial performance, corporate operation, and management efficiency. It is one of the financial statements that can show the flow of corporate profits and costs over a specific period.

The income statement focuses mainly on four important items: revenue, cost, loss, and profit.

Revenue can divide into two areas: operating income and non-operating income, the revenue from primary activity through product sales, i.e., product producers and wholesale and retail or distributors. Non-operating profits are profits earned through bus advertising, royalty payments, and rental profits, generally made through secondary non-core corporate activities.

Gain refers to the net profit obtained from one-time non-business activities and generally refers to the net currency accepted through other activities or long-term asset sales rather than directly selling products or services.

In addition, the cost of continuing to make profits through corporate activities and operations is called expense.

The income statement applies as the basis for confirming the company’s operational activities and business profitability and provides insight to management in determining the overall direction of the business and preparing strategies for generating corporate profits.

  • Cash flow statement

The cash flow statement is consisted of three main parts: operations, investment, and financing, and is a financial statement that provides information on overall cash inflows and outflows, including corporate activities over a specific period. In general, operations are the contents of all corporate activity transactions, investment is the cash flow of investment to know the outcome of gains and losses, and capital raising is the overview of the cash to be known through corporate debt and capital.

Cash flow statements are very helpful in predicting costs through short-term planning and are also important in knowing and managing the financial flow of a company. It can use when management makes decisions in regulating and facilitating operations through various information.

  • Statement of owner’s equity

The owner’s capital statement indicates the overall owner’s business stability and financial soundness. It is one of the important financial statements that show the overall cash flow through the business and the total assets and total liabilities. In general, partnerships, private companies, and private holding companies use this financial statement, which employers use as important data when making decisions on the direction and expansion of the business.

The statements of owner’s equity can affect the following business decisions:

  • Capital investment
  • Business expansion
  • Circulation of stocks
  • Profit distribution
  • Diversification of business

References

By Heon Jeong Yi

She is a student of Concordia International University student.

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