2.1.1 Introduction to Finance

Introduction to Finance

Key Definitions

Finance: The aspect of a business that provides the numbers to help managers make better decisions, and it helps the managers count what is happening and what has happened within the business. 

Start-Up: The process of starting a new business with all of the financing. 

Working Capital: The money used in the day-to-day running of the business. 

Fixed Cost: A cost that does not change depending on the change in the number of sales, such as rent or staff salaries.

Variable Cost: A cost that changes depending on the change in the number of sales, such as the cost of buying raw materials. 

Finance and Start-Up

The main underlying problem with business start-up is the fact that people get 'starry-eyed' about the process of starting their own business. They start to believe their own publicity and assume that their restaurant is going to be 'hot and trendy' from the first day it is open to the public, The consequence of this is that too much of the start-up capital is tied into fixed assets, such as interior design and equipment, leaving not enough to be used as working capital for the day-to-day running of the business. 

To be an entrepreneur means that you have to be optimistic but also realistic - especially as optimists often do not look for the bad side of a situation. They expect business to be fantastic from day one, ignoring the evidence that most businesses find it hard to establish a loyal base of customers at the start of the business's life. For most new businesses it is wise to set aside half the start-up capital to be reserved as working capital. Once the weekly earnings for the business are high enough the incoming money will be enough to pay for all costs that need to be paid out. 

Working Capital

The key to a successful business is to keep on top of the working capital. The priority of a business should be to keep an everyday check on costs, credit transactions and cash payments. This can often be difficult if there are multiple people working for you, as each could expect to be given the authority to make a decision. If lots of people are spending the money it would be almost impossible to keep track of each purchase and the expenditure. 

New entrepreneurs often choose one person to be the person with sole control over company expenditure. A clever entrepreneur will make sure to give the job to someone else, as it means that even the business owner will be forced to justify reasons for spending the amount they wish to. As well as keeping track of day-to-day spending a manager needs to:

• Identify the costs involved in making a product, especially as this can help to determine the selling price for the product.
  
• Work out how many of each product they need to sell in order to make a profit from it.
  
• Find out how much capital they will need in the upcoming months and then decide on the best way to obtain this needed money.
  
• Keep a tight control over the way in which the firm's money is spent. 

Key Financial Concerns for New Business Start-Ups

The starting point for this is to figure out the 3 main concerns for a new business start-up. 

1. Cost of moving from a business idea to opening the doors of the business on its first day of trading.

For example, for a new clothes shop this will include a huge range of clothing items to sell, the rent of a retail premise to sell the clothes in, and other expenses, which could potentially cost the owner £40 000.

2. How much the running costs for the business will be. 

These costs tend to come in 2 parts: the fixed costs and the variable costs. Every entrepreneur needs a basic but solid understanding into the running costs of their business.

The fixed costs are those that do not change depending on how many products the business sells or how well the business is doing commercially or financially. This includes the staff salaries, the rent of the building, heating and electricity bills etc. 

On the other hand the variable costs do change depending on how many products the business sells, and they influence how well the business is doing commercially, but not financially. This includes the costs of the items that the business sells, and the production costs for each product. 

3. How much revenue can be expected from the customers served by the business. 

This depends on the number of customers that are served by the business in a set amount of time, for example a month, and how much they spend on the products. Even though this is easy to calculate it is difficult to predict exactly what the figures will be. Market research is sometimes used here to help make a sales forecast, but even then it is based on estimates and not exact figures. Small businesses will always have the same problem of how to forecast the numbers of loyal customers that can be expected.

Raising Finance

When a business is operating fully and successfully cash coming in from the customer will provide all the finance the business needs for an effective operation. Until then, however, raising finance is an important issue for the business, especially for young entrepreneurs who have little personal capital avaliable to use. The following table lists the sources of finance that is avaliable to firms:

SHORT TERM (LESS THAN 1 YEAR)
Bank Overdraft	·         Allowing the firm’s bank account to go into the red up to an agreed limit. ·         Flexible and easy to arrange, but interest charges are high.
Trade Credit	·         Suppliers agree to accept cash payment at a given date in the future. ·         Failure to pay on time can present problems for future orders.
MEDIUM TERM (2 – 4 YEARS)
Bank Term Loan	·         Banks lend sums of money, often at a fixed interest rate, to be repaid over a fixed period. ·         Makes financial planning easy but interest rates can be high, particularly for small firms.
Leasing	·         Firms sign a contract to pay a rental fee to the owner of an asset in return for the use of that asset over a period of time, typically 2 to 4 years. ·         This can be expensive, but avoids large cash outflows when buying new assets.
LONG TERM (5+ YEARS)
Owner’s Savings	·         Most small businesses are set up with the owner’s savings. ·         They are ‘interest free’ but will be lost if the business fails. ·         Banks will not provide a loan or overdraft unless the owners are sharing the financial risk.
Sale of Shares	·         Private and public limited companies can sell shares in the ownership of the company. ·         In return the shareholders gain a say in how the business is run and are entitled to a share of the profits.
Reinvested Profits	·         Profits are the most important source of long term finance. ·         This form of finance is good because there are no interest payments to be made.
Venture Capital Loans	·         These specialist providers of risk capital can provide large sums. ·         The finance is usually partly loan capital and partly share capital.

Financial Management for an Established Business

Companies that stay small tend to keep focused on cash. Bigger businesses find a developing disconnect between the revenue and cost aspects of a business. Marketing people boast about rising sales while factory managers worry about costs becoming 'out of control'. Often the solution to this is to bring in a budgetary control system. This used to be a nightmare, but modern software makes it relatively easy to set and monitor spending. A budgeting system can make sure that the marketing department's efforts to boost sales are kept related to the costs being incurred to manufacture and distribute the products - therefore making sure that profits are made. 

The other thing that businesses need to consider is how to respond if the sales start to boom, perhaps because a strong trend is moving through in the firm's direction. A boom is great but also difficult to handle as they require a lot of cash to finance extra staff, more/bigger premises, and also sometimes a bigger advertising campaign in order to meet the needs of the rapid expansion. Budgeting is helpful here, but a cash flow forecast would be even more beneficial.