Introduction To

Finance

BUS333 Business Finance

By Abubakar Karaye

CONTENTS

Overview of Business Finance 01

Important of Cash Flows 02

The Objective of Financial Management 03

Form of Assets 04

Investment Process 05

Market Players 06

Recent Development in Business Finance

07

1. What is Business Finance ?

2. Two Main Theme of Finance

3. Types of Business Finance

4. Major sources of Finance for Small and New Businesses

5. The Financial Manager

Overview of Business Finance

01

What is Finance and Investment?

Finance study of how individuals, institutions, governments, and businesses acquire, spend, and manage financial resources

Business finance refers to the raising and managing of funds by business organizations.

Business financing is the process of the raising and acquiring money for new business or new project of an existing business.

Financing a business mean investing money and other resources into the Business.

Financing and Investing can be used interchangeably. Investment is the current commitment of money or other resources in the

expectation of reaping future benefits. For example, an individual might purchase shares of stock anticipating that the future proceeds from the shares will justify both the time that her money is tied up as well as the risk of the investment.

The Two Main Themes of Finance

Businesses and companies typically moves through five stages in their life: development, start-up, survival, rapid growth, and maturity.

Personal finance: Personal finance is the study of how individuals prepare for financial emergencies, protection against premature death and the loss of property, and accumulate wealth over time. Personal finance focuses on planning decisions made by individuals, regarding saving and investment of their financial resources.

Entrepreneurial finance: Entrepreneurial finance is the study of how growth driven, performance focused, early stage firms (from development through early rapid growth) raise financial capital and manage their operations and assets. Entrepreneurial finance focuses on operational and financial issues faced by early stage firms.

Types of Business Financing

Short term finance: This is the process of satisfying the business’s need for fund for a short period of time usually less than a year. This is also known as “Liquidity Financing” or “Working Capital Financing”.

Medium term finance: This is the financing of a business or a project for a period between three to five years. In using this type of financing, a business should look for the balance between risk and return. This type of finance is mostly used when long term capital is not available. This type of finance is more conservative than the long term finance, but has more risk than short term.

Long term finance: This is the funding of a business or a project of a business for a long term period usually more than 10 years. This is also Known as ‘fixed capital financing”.

Types of Business Finance

Example of Types of Business Financing

Major Sources of Finance for Small and New Businesses

There are seven Major sources of finance for Small and new businesses

1. Personal Investment or Personal Savings

2. Venture Capital

3. Business Angels

4. Government Assistant

5. Bank Loans and Overdraft

6. Financial Bootstrapping

7. Buyouts

Major Sources of Finance for Small and New Businesses

1. Personal Investment or Personal Savings: This is when an individual or group of people used their saving to invest in a new business. This is the oldest and safer form of financing

2. Venture Capital: This form of financing entails transfer of knowledge, idea or cash for to a business. An entrepreneur can join a business by exchanging his new strategic advice and ideas as a capital or can provide cash or other assets as his share of capital.

3. Business Angels: These are the professional investors who invest substantial part of their wealth in a prospective innovative companies. This mostly found in Developed countries

4. Government Assistant: Government may be a partner or assist a new company with funds. This is mostly found in developed communist countries like China.

5. Bank Loans and Overdraft: Bank loans can be a long-term, and short-term mode of financing business. Bank overdraft is a short-term form of financing.

6. Financial Bootstrapping: This is a process of building a new business by inviting capable friends, committed employees, capable relatives and growing customers without having to seek out the assistance of a bank loan.

7. Buyouts: A buyout is the process of gaining a substantial share of another company, either through outright purchase of the company or by obtaining a controlling share of an under valued companies.

The Financial Manager

A financial manager plays a critical role in providing financial guidance and support to a company. His most important duty is to create value by achieving higher performance. Other duties and responsibilities of a financial manager are:

Prepare financial statements, business activity reports, and business forecasts

Monitor financial details to ensure that legal requirements are met

Supervise accountants and other employees who do financial reporting and budgets

Review company financial reports and seek ways to reduce costs

Analyze market trends to find opportunities for growth and expansions

Help management make financial decisions by providing his professional view

Providing out-of-office services such as accounts payable, collection and payroll

Providing insights on the financial health of the organization

Developing relationships with external contacts such as auditors, solicitors, consultant and Tax officers.

1. Identification of Cash Flows

2. Timing of Cash Flows

3. Risk of Cash Flows

Important of Cash Flows 02

Identification of Cash Flows

The most important job of a financial manager is to create value from the firm’s capital budgeting, financing, and net working capital activities. How do financial managers create

value?

• A company must create more cash flow than it spends. A company must paid back its shareholders more than the money they invest in the company. This is called creating shareholder value or creating company value. This can be achieved when a company achieved a higher financial performance. To achieve this a company has to:

Acquire assets that generate more cash than they cost

Sell bonds, stocks, and other financial instruments that raise more cash than they cost.

This will create extra cash flow that can be turned into profit and subsequently to higher financial performance

Timing of Cash Flows and Risk of Cash Flow

The value of an investment made by a firm depends on the timing of cash flow. One of the most important principles of finance is that individuals prefer to receive cash flows earlier rather than later. One dollar received today is worth

more than one dollar received next year.

The firm must also consider risk, the amount and timing of cash flows are not usually known with certainty. Most investors have are risk averse, therefore, they don’t like taking risks.

The Objective of Financial Management

The Ultimate objective of financial management is to add value for the owners. In other word, The objective of financial management is to create return to companies investors. These returns can be in two form:

Stock value appreciation (Capital gain)

Dividend

Stock value appreciation is increase in the price of the company shares in the financial markets.

Dividend is a sum of money paid on regular basis by a company to its shareholders out of its profits or reserves, after deducting tax.

For a company to achieve this objective, there are other goals that it needs to achieve that will ultimately leads to the achievement of the main goal.

The Objective of Financial Management

These goals are:

Going Concern

Liquidity and Solvency

Competitive advantage

Maximize sales or Turnover

market share

Minimize cost

Maximize profits

Maintain steady earnings growth

Can a company increase it’s market share or unit sales by lower it’s prices or relax it’s credit terms? Similarly, can a company cut costs by cancelling a research and development project or department. Also can a company avoid bankruptcy by never borrowing any money or never taking any risks?

All these actions may not be in the companies shareholders’ best interests.

Form of Assets in Finance

An Asset: an asset is any resource owned or controlled by an economic entity. Asset is anything that can be used to produce positive economic value. Assets represent value of ownership that can be converted into cash. In other word, An asset is a resource with economic value that an individual, company, or group of people owns or controls with the expectation that it will provide a future benefit. Assets are Purchased or created to increase a firm's value or benefit the firm's operations.

There are Two main form of assets: Real Assets and Financial Assets

Real Assets: This are assets used to produce goods and services. The material wealth of a society is determined by the productive capacity of its economy, that is, the goods and services its members can create. This capacity is a function of the real assets of the economy, these include; the land, buildings, equipment, and knowledge that can be used to produce goods and services.

Form of Assets in Finance

Financial Assets: These assets are claims on real assets or the income generated by them. financial assets Include stocks , bonds and derivatives instruments. Such securities are no more than sheets of paper or more likely computer entries and do not contribute directly to the productive capacity of the economy. Instead, these assets are the means by which individuals in well-developed economies hold their claims on real assets. Financial assets are claims to the income generated by real assets (or claims on income from the government). Financial Assets are also known as “Market securities” or “Securities”

While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors.

Therefore, If we cannot own or create our own car factory (a real asset), we can still buy shares in General Motors or Toyota (financial assets) and thus, share in the income derived from the production of automobiles.

Investment Process

Portfolio: A Person’s portfolio is simply his collection of investment assets. Once a person’s portfolio is established, it is updated or rebalanced by selling existing securities and using the proceeds to buy new securities, and/or by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the portfolio.

Investment assets can be categorized into broad asset classes, this include among others;

Stocks: This are shares of a company, they are classified into Ordinary Shares & Preference Shares. Owners of Ordinary Shares are the real owners of the company, while Preference Shares does not exert ownership, but owners of preference shares have the first right in the distribution of dividend.

Bonds: A bond is an instrument of indebtedness of the bond issuer to the holders. Bond is another financial asset that a company or government issue to the public to raise fund. A bond is paid back with interest. The most common types of bonds include municipal bonds and corporate bonds.

Investment Process

Commodities: Commodities are raw materials, finished goods, of financial product which their prices are determine by the market forces. Commodities include; grains, gold, silver, copper, rice, oil, cotton, coffee, sugar, and cocoa, currency, etc.

Real estate: Real estate is property consisting of land and the buildings on it. It may be a piece of land that consist of natural resources such as crops, minerals or water.

How do we create a portfolio?

Investors make two types of decisions in constructing their portfolios:

Asset Allocation: Asset allocation decision is the choice among broad classes of assets, It is the allocation of an investment portfolio across broad asset classes.

Security Selection: Security selection decision is the choice of which particular securities to hold within each asset class. It is the choice of specific securities within each asset class.

Investment Process

A “Top-down” portfolio construction starts with asset allocation. For example, an individual

who currently holds all of his money in a bank account would first decide what proportion of

the overall portfolio ought to be moved into stocks, bonds, and so on. In this way, the broad

features of the portfolio are established.

A top-down investor first makes asset allocation decisions before turning to the decision of the particular securities to be held in each asset class.

Security Analysis: Security analysis, on the other hand, involves the valuation of particular securities that might be included in the portfolio. For example, an investor might ask whether Facebook or Twitter is more attractively priced. Both bonds and stocks must be evaluated for investment attractiveness.

Market Players

The major market players in the financial markets are:

Companies: companies are net borrowers. They raise capital to pay for investments in plant and equipment. The income generated by those real assets provides the returns to investors who purchase the securities issued by the company.

Households: Household typically are net savers. They purchase the securities issued by firms that need to raise funds.

Governments: Government can be partner, borrowers or lenders, depending on the relationship between tax revenue and government expenditures.

Financial Intermediaries: These are Institutions that connect borrowers and lenders by accepting funds from lenders and loaning it to the borrowers. For example, a bank raises funds by borrowing (taking deposits) and lending that money to other borrowers.

Market Players

Investment Bankers: This is a firms that specialized in the sale of new financial assets to the public, typically by underwriting the issue. Companies raise much of their capital by selling securities to the public.

Investment companies: These are Firms that manages investors’ fund. They are companies that manage the money and financial assets of investors. An investment company may manage several mutual funds. This include brokerage firms, and mutual fund operators.

Most household portfolios are not large enough to be spread among a wide variety of assets It is very expensive in terms of brokerage fees and research cost to purchase one or two shares of many different firms.

However, mutual funds have the advantage of large-scale trading and portfolio management while participating investors are assigned a prorated share of the total funds according to the size of their investment. This system gives small investors advantages and the investors will be willing to pay for a management fee to the mutual fund operator.

Recent Development in Business Finance

Five recently important trends have changed the contemporary investment environment:

Globalization,

Securitization,

Financial engineering

Information and computer networks

Financial crises

Globalization: The world is now a global village. Globalization in finance is the tendency toward a worldwide investment environment, and the integration of international capital markets. Increasingly efficient communication technology and the dismantling of regulatory constraints have encouraged globalization in recent years.

Recent Development in Business Finance

For Example an Individual or a company can participate in foreign investment opportunities in U.S or else where in several ways:

Purchase foreign securities using American Depository Receipts (ADRs), which are

domestically traded securities that represent claims to shares of foreign stocks.

Purchase foreign securities that are offered in dollars.

Buy mutual funds that invest internationally, and

Buy derivative securities with payoffs that depend on prices in foreign security markets.

Securitization: Pooling loans into standardized securities backed by those loans, which can then be traded like any other security in the capital market. The securitization of mortgages means that mortgages can be traded just like other securities in the market. Other loans that have been securitized in the U.S include car loans, student loans, home equity loans, credit card loans, and debts of firms.

Recent Development in Business Finance

Financial Engineering: Financial engineering refers to the creation of new securities by unbundling; which is the breaking up and allocating the cash flows from one security to create several new securities, or by bundling; which is combining more than one security into a composite security. In other word, it is the process of creating and designing securities with custom-tailored characteristics.

Financial engineers view securities as bundles of possible risky cash flows that may be carved up and rearranged according to the needs or desires of traders in the security markets.

Computer Networks: The Internet and other advances in computer networking have transformed many sectors of the economy, as well as the financial sector. These advances bring about the introduction of new securities such as tech stocks, crypto currencies and etc.

Financial Crises: The aftermath of financial crises help expose loopholes in financial markets, therefore, helps in creating and solidify new regulations that makes the capital market more efficient. Although financial crises is an undesirable event, it also have its positive implication.

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