November 22, 2010
Basic Issues Of Business Finance
A business cannot stay in business for long if it can’t cover its payroll or pay its suppliers. On the other hand, if it is awash in cash, it might be missing potential income from investing the surplus. Figuring out what the company’s cash balance should be, and what to do if the actual amount is above or below that, are the subject matter of business finance.
The money required by a business can be treated as the some of the money needed for normal operations plus the money needed for development efforts. How does one determine the amount of cash required for business operations? For ongoing businesses, this can generally be projected based on accounting information showing how much cash has been needed recently. This should be adjusted for any anticipated changes in the business.
Money needed for development efforts is a bit more difficult to project. Generally each effort should be treated as a project and should have a forecast or budget projecting its need for cash over time. The sum of all of the project cash requirements plus the operations cash requirements gives the total business cash requirements.
The revenue, or incoming cash of the business can be estimated in much the same way. Sales projections can be applied to historical revenue information to project future revenue from operations. Project revenue can be involved. Some projects generate direct revenue, some generate savings, which reduce costs, some do both, and some don’t actually have any direct impact on revenue or costs. Basically any impacts should be estimated and fed into a model for the total projected costs of the business.
Subtracting expenses from revenue yields cash flow. If the cash flow is negative for a long enough period, the business will become insolvent. It should attempt to have enough cash available to cover any expected negative cash flow. It is generally prudent to have more than this amount, as unexpected events should always be allowed for. Risk management should decide how much extra is needed.
Short term deficits will generally be handled by borrowing money. This could come from a bank, either via drawing on a line of credit or acquiring a loan. Another vehicle for short term debt would be to issue commercial paper via a money market. The commercial paper option is only available to larger corporations with good credit ratings. Other means such as receivables financing may be used if neither of the above is available.
With long term deficits, the business has a choice between debt and equity. Debt may take the form of bonds or bank loans. Raising money by the equity route means selling stock, or some stock related security.
The simplest way of dealing with short term surpluses is simply leaving them in bank accounts. Buying Treasury bills is another low cost, high security option. A third choice would be to go to a money market and buy some commercial paper.
Once choice for long term surplus funds would be greater investment. The business could invest in additional development, or it could invest in other companies by acquiring them. This is getting out of the scope of business finance, but sometimes the different branches of management don’t really separate out all that well.
The other alternative would be to return the money to the shareholders. This can be done by issuing larger dividends. Another approach would be to buy back some of the company’s stock. This increases the value of the remaining shares, which indirectly adds to shareholder value.
Business finance is a key function in today’s challenging business environment. Doing it right can protect the company from excessive risk while enhancing overall returns. Not doing it right can be the end of the company.
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