Business Finance
Topic Eight

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Business Finance

Business finance is a term that encompasses a wide range of activities pertaining to the management of money and other valuable assets. Small business owners must have a solid understanding of the principles of finance to keep their companies profitable.

The Financial Sector - The financial sector can be defined as the interaction of lenders and borrowers in financial markets within a regulatory framework. Key in this interaction is lending and borrowing of financial capital or money. This lending and borrowing is usually achieved through financial intermediaries such as commercial banks, brokers and other financial institutions. 

Financial institutions provide services of financial intermediation between lenders and borrowers. The financial institutions of most economies include:

  • Central Bank
  • Commercial banks,
  • Stock exchange,
  • Insurance companies,
  • Credit unions,
  • Mutual funds,
  • Development banks,
  • Building societies,
  • Informal credit institutions,
  • Investment trust companies,
  • Deposit insurance corporation.
  • Financial services commissions.

Role of Commercial Banks

The main functions of commercial banks are:

Mobilizing Saving for Capital Formation - The commercial banks help in mobilizing savings through network of branch banking. They allow citizens to deposit their monies into the commercial banks and pay these depositors a rate of interest.  These commercial banks then use these deposits to lend to businesses and individuals in society. 

Financing Industry - The commercial banks finance the industrial sector in a number of ways. They provide short-term, medium-term and long-term loans to industry.

Financing Trade - The commercial banks also help in financing both internal and external trade. The banks provide loans to businesses which assist in the provision of goods and services in the economy.

Financing Consumer - People in less developed countries having low incomes do not possess sufficient financial resources to buy durable consumer goods. The commercial banks advance loans to these consumers for the purchase of such items. 

Services Offered by Commercial Banks

Here is a brief description of each type of account:

Savings Accounts - These are intended to provide an incentive for you to save money.

Basic Checking Accounts - These offer a limited set of services at a low cost. You will be able to perform basic functions, such as check writing.   

Money Market Deposit Accounts - These accounts invest your balance in short-term debt such as commercial paper and treasury bills.

Certificates of Deposit (CDs) - These are also known as time deposits, because the account holder has agreed to keep the money in the account for a specified amount of time.

Advancing of Loans - Banks are profit oriented business organizations. So they have to advance loan to public and generate interest from them as profit.

Discounting of Bills of Exchange - Bill of exchange is a negotiable instrument, which is accepted by the debtor, drawn upon him/her by the creditor and agrees to pay the amount mentioned on maturity.  Under this arrangement, banks purchase bill of exchange from holder in discount after making some marginal deduction in the form of commission. The banks pay the deducted value to the holders when traders discount it into bank.

Foreign Currency Exchange - As the requirement of customers, banks exchange foreign currencies with local currencies, which is essential to settle down the dues in the international trade.

Functions of the Central Bank

A central bank is a monopolized and often nationalized institution given privileged and control over the production and distribution of money and credit. The main functions of a central bank include:

  • Issuer of notes and coins – the Central Bank is the only issuer of notes and coins in a country.
  • Banker’s bank - the Central Banks is the facilitator of loans to commercial banks;
  • Government’s bank - the Central Bank acts on behalf of the government for all financial transactions. Additionally, if the government needs loans the Central Bank facilitates this;
  • Management of the economy – the Central Bank usually assists the central government in managing the economy through monetary policy.
  • Lender of last resort - if commercial banks get into liquidity shortages meaning that they cannot honour their financial obligations, then the Central Bank is able to lend the commercial banks sufficient funds to avoid the bank running short of money.
  • Clearing House Function - banks receive cheques drawn on the other banks from their customers which they have to realise from drawee banks. Similarly, cheques on a particular bank are drawn and passed into the hands of other banks which have to realise them from the drawee banks. The central bank provides clearing facilities, i.e., facilities for banks to come together every day and set off their chequing claims.

Relationship between the Central Bank and Commercial Banks

The Central Bank is the head of the financial system. Most financial institutions including commercial banks are regulated and monitored by the Central Bank.  All commercial banks must keep an account with the Central Bank. These balances are used for cheque clearing purposes between banks.  Payments for cheques between banks are set off at the Central Bank’s clearing house. The Central Bank can also demand commercial banks to deposit a certain percentage of their total deposits with the central bank in order to control the money supply.  The Central Bank dictates the interest rate that commercial banks can offer by setting the bank rate.

Sources of Short Term and Long Term Finance

Businesses need financing in order to achieve the goals and objectives of the business enterprise.  Financing is often called capital and there are two main forms of capital:

  • Debt – which is borrowing and;
  • Equity which is the selling of shares in order to raise the required capital of the business.

The sources of financing can either be short term or long term.  There are different vehicles through which short-term and long-term financing is made available.

Short-term financing is financing with duration of up to one year. Short-term financing can be done using the following financial instruments −

  • Personal Savings and other "nest-eggs" – a business owner will often invest personal cash balances into a start-up. This is a cheap form of finance and it is readily available.
  • Bank Loans – in this case a fixed amount of money is borrowed by the business owner from lending institutions including commercial banks and even credit unions.
  • Commercial Paper – this is an unsecured promissory note with a pre-noted maturity date. Originally, it is issued by large corporations to raise money to meet the short-term debt obligations. 
  • Overdraft – an overdraft is an extension of credit from a lending institution when an account reaches zero.
  • Supplier Credit – this is when suppliers offer goods to businesses with the agreement that when the goods are sold, the business will pay the supplier what is owed to it.
  • Letter of Credit – a financial institution or a similar party issues this document to a seller of goods or services. The seller provides that the issuer will definitely pay the seller for goods or services delivered to a third-party buyer. The issuer then seeks reimbursement to be met by the buyer or by the buyer's bank.

Long-Term Financing

Long-term financing is usually granted to businesses that are in large-scale operations that need large and heavy equipment.  Such financing arrangements will be of a longer term in nature and much more complicated.  The following are some of the sources of long-term financing:

  • Bank Loans or Debt Financing – such loans are usually with much longer duration with higher interest payments due to the larger amount of risk.
  • Bonds or Debt Financing – the business can also borrow in the form of the issuance of bonds on the financial market. When the business issues a bond, this bond is sold to members of the public; the business which is issuing the bond is therefore borrowing from the public. 
  • Equity Financing - Equity financing involves the selling of shares of the business to investors. This will mean that the persons who are purchasing shares of the business will be purchasing portions of the business. 
  • Business angels- Business angels are professional investors who typically invest in your business. 
  • Venture capital - is a specific kind of share investment that is made by funds managed by professional investors. Venture capitalists rarely invest in genuine start-ups or small businesses.   Private equity is another term for venture capital.
  • Government grants – Some governments in some countries give grants to assist small entrepreneurs to start their own business.
  • Crowd fundingthis is the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet.

Savings and Investments

Saving and investing are both equally important to individuals and businesses. Savings are usually done to achieve short term payment goals and needs and are low risk in nature. Investments are made with the aim of making larger profits and, therefore, involve bearing higher levels of risk.

The following are the different forms of savings in the Caribbean:

  • Deposits at Commercial Banks – both individuals and businesses deposit monies at commercial banks.
  • Credit Unions - savings can also be done through credit unions.
  • Mutual Funds - a mutual fund is a professionally-managed trust that pools the savings of many investors and invests them in securities like stocks, bonds and short-term money market instruments
  • SouSou - besides formal financial institutions, there are also some informal financial institutions and a very good example is that of a SouSou which is also known as box, syndicate or partner in other Caribbean territories. Sousou which is usually headed by one person, allows members to deposit money who reap the rewards of a return of their monies at some later date.

The Role of the Stock Market

The main purpose of a stock exchange is to allow companies to raise financial capital from a large pool of investors (the primary market) and to provide a market for investors to later sell their shares and stocks (securities) in those companies (secondary market).

Some of the important functions of stock exchange are as follows:

  • Mobilization of capital – by allowing investors to be able to buy shares of listed companies and being able to allow sellers of shares to sell their shares on the secondary market, a stock exchange assists in the mobilization of capital and the efficient allocation of such capital;
  • Economic indicator – changes in economic conditions are reflected in the share prices of companies listed on the stock exchange. The overall measure of the activities on the stock market is known as a financial index. Changes in this index can serve to indicate where the economy is heading;
  • Pricing of securities – the stock market helps to determine the value of securities.
  • Contributes to economic growth – because stock markets assist in the mobilization of capital, they can contribute to economic growth and development
  • Liquidity – the main function of a stock market is to provide a ready market for sale and purchase of securities. Liquidity describes the degree to which an asset or security can be quickly sold in the market for cash. The presence of a stock exchange market gives assurance to investors that their investment can be converted into cash whenever they desire.

Role of a Deposit Insurance Corporation

Deposit insurance, also called depository insurance, is the protection provided usually by a government agency to depositors against risk of loss arising from failure of a bank or other depository institution. Deposit insurance pays claims from a pool of funds to which every depository institution regularly contributes. However, it covers only a fixed maximum amount per account holder.

Role of a Securities and Exchange Corporation

The Securities and Exchange Commission works to oversee corporate takeovers and to protect investors. 

Accounting for the Sole Trader

Single entry system of bookkeeping is the oldest method of maintaining financial records in which an entry is made for every financial transaction. In this system, the corresponding opposite entry is not made because the transactions are recorded only once. Full record keeping of transactions is not done due to a single entry of every transaction. It mainly keeps track of the transactions relating to cash receipts and disbursements.  This method of keeping records is primarily used by a sole proprietorship and partnership firms.

Double Entry System is the scientific method of keeping financial records. This system is based on the principle of duality, i.e. every transaction has a dual aspect. Each transaction affects two accounts at the same time, in which one account is debited while the other is credited.

Balance Sheet

The balance sheet of statement of financial position reports the financial position of a business, including a sole proprietorship, at a specific point in time

Statement of Financial Performance

The statement of financial performance, also known as the income statement or trading account, reports the results of earnings activities for a specific time period, such as a month, quarter or year. The net income of the sole proprietorship is the excess of revenues over expenses for that time. If expenses exceed revenues, the sole proprietorship incurs a net loss. Revenues are the increases in owners' capital from the sale of goods or the performance of services. Other types of revenues include interest, dividends and rental income. Expenses are the costs incurred in the course of carrying out the business.

Statement of Cash Flows

The fourth financial statement of a sole proprietorship is the statement of cash flows, which describes where the cash came from and where it went during the period.

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