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Business Finance: Meaning, Sources, and Types 

July 21, 2022 • 10862 views

Business finance is crucial for entrepreneurs, serving as the lifeblood for starting and sustaining a business. Securing capital is a central focus, often demanding the majority of an entrepreneur's time and effort. Success is not solely determined by the quality of a product or service. It also depends on the ability to secure and manage adequate financial resources. In essence, thriving businesses need to know the meaning of business finance to fuel their operations.
Read on to learn about the basics of business finance and different types of business finance instruments.

What is Business Finance?

Business finance refers to the funds that a business requires to establish, pay for all business activities, and expand.  
This capital is needed to rent office space, pay all the employees of the business, pay for any raw material required, and pay for machinery or long-term assets required to make its products. Further, business finance can also be required for intangible assets of a business such as patents, trademarks, and copyrights.  
Any activity that needs to be done to secure the money needed to run a business comes under the purview of business finance.  

Why is Business Finance Important?

Following are some of the reasons why understanding the meaning of business finance is important:

  • Maximisation of Wealth

Business finance is not just about short-term profit. It focuses on long-term wealth creation for shareholders. This means making strategic financial decisions that ensure the organisation's sustainable growth and value appreciation.

  • Constant Availability of Money

Having readily available funds when needed is vital for any business. Effective financial management helps maintain smooth operations, navigate economic fluctuations, and avoid cash flow disruptions.

  • Optimum Capital Structure

Finding the optimal mix of equity and debt is crucial. Business finance helps businesses achieve this balance, avoiding excessive debt burden and maintaining ownership control. 

  • Utilisation of Funds

Efficient utilisation of resources is paramount. Business finance principles guide in allocating funds effectively, minimising unnecessary expenses, and making smart investments that contribute to the organisation's overall success.

Why Do You Need Small Business Financing?

The importance of business or MSME Finance speaks for itself.

  • Business finance allows founders and entrepreneurs to acquire essential assets, pay for talent, and purchase office space, along with anything else that a business needs to get off the ground.  
  • Once such financing is secured, a business owner can focus on running their business and taking care of the day-to-day needs and the long-term of the business. It allows business owners to stop worrying about funding and start working towards their goals.  
  • It can help a business be prepared for unforeseen contingencies. If a business suddenly meets high demand, it can hire enough workers to be able to meet such demand if they have adequate finances.  

Sources of Business Finance

The sources of Business Finance can be classified in three primary ways. This will help entrepreneurs gain a complete understanding of how to finance a business in India.  
1.    Based on Time

  • Long-term Financing: This refers to financing for a business that is available for more than five years. For example, selling shares of a company allows a company to generate funding for the long term. A business can also avail a long-term business loan to secure funding for more than five years.  
  • Medium-term Financing: This refers to funding that has a period of more than one year but less than five years. Examples of such financing include taking public deposits, issuing commercial paper, medium-term loans from a bank or financial institution, or lease financing.  
  • Short-term Financing: Short-term financing can be used to meet the needs of a business for less than one year. For example, availing of a working capital loan allows a business to meet its current liabilities. Other examples include an overdraft facility, a line of credit or credit cards.  

2.    Based on Generation 

  • Internally Generated Funds: This refers to the funds that have been generated from within the company itself. It includes any profit that the business may have seen through its operation, retained earnings that can be used to fund future operations, and any money raised through the sale of business assets.  
  • Externally Generated Funds: These are funds that have been sourced from outside the company. It includes any debt which was availed from a bank or financial institution, any debentures which were issued, or any shares of the company that were sold through private or public placement.  

3.    Based on Ownership 

  • Founder’s Funds: This refers to capital that the founder or founders bring to the table. This financing allows founders to retain ownership and control of a company and to benefit from its long-term growth. For example, if a business owner funds ?10,00,000 into their business, then that forms a part of the founder’s funds.   
  • Borrowed Funds: This refers to capital that a business needs to repay after a certain period. These funds may be borrowed from the public through debentures or from financial institutions through different types of credit. This is another type of small business lending.  

Key Components of Business Finance

The following are the key components of business finance:

  • Investment Analysis:

Encompasses the evaluation of potential investment opportunities to ascertain their profitability and feasibility. Financial managers analyse data, assess risks and benefits, and make informed decisions on allocating financial resources.

  • Financial Planning:

Involves crafting a strategic roadmap for the organisation's financial goals, objectives, and strategies. This includes formulating budgets, establishing financial targets, and implementing policies and procedures.

  • Financial Reporting and Analysis:

Helps to prepare crucial financial statements like income statements, balance sheets, and cash flow statements. Financial managers analyse this data to identify trends, forecast future performance, and make informed decisions regarding the organisation’s financial strategy.

  • Capital Budgeting:

With business financing, you need to make substantial investment decisions, such as acquiring new equipment or expanding into new markets. Financial managers meticulously analyse the costs and benefits of potential capital investments, making well-informed decisions on the allocation of financial resources.

  • Risk Management:

Entails the identification, assessment, and mitigation of risks associated with the organisation’s operations. Financial managers must adeptly recognise potential risks, formulate strategies to mitigate them, and continuously monitor risk exposure.

  • Financial Management:

This implies to optimisation of the organisation's financial resources, encompassing cash, accounts receivable, accounts payable, and inventory. Financial managers strive to maximise profitability while minimising risks through efficient resource utilisation.

ALSO READ :- The Ultimate Guide on Business Asset Loans in India…!

Types of Business Finance and How to Choose the Right One?

There are two primary types of Business Finance:

  • Equity Financing 

Equity financing refers to financing that is generated by selling ownership or stake in a company. Equity financing can be raised by selling ordinary shares or preference shares of a company. This type of financing allows a company to raise funds without going into debt. The incentive for investors to purchase the equity of a company is that the growth of the company can increase the value of such shares, regardless of whether they are ordinary shares or preference shares.  
If it is a private company, then the equity financing can only be raised through private means. A founder cannot approach the public to raise such money. However, once a company meets certain requirements, it can become a publicly traded company and raise money from the general public.   

  • Debt Financing 

This refers to money that is raised by borrowing. Debt financing allows companies to raise funds without the sale of ownership or control of the company. Debt financing can also be relatively easy to obtain when compared to equity financing.  
Debt financing can be availed by approaching banks or other types of financial institutions. There are a lot of ways credit can be availed, including through Business Loan, working capital loans, and the sale of debentures in the form of small business financing
The decision between equity and debt financing should align with the business's specific circumstances, goals, and risk tolerance. It's often beneficial to consult with financial advisors or professionals to make an informed decision tailored to the business's unique needs.

How to Get Business Finance and What to Expect from the Process?

Getting a business financing loan can be a complex and challenging process, but it is also an important way to acquire the funding you need to grow your business. Here is a step-by-step guide to the process and what to expect along the way:

  • Step 1: Determine Your Financing Needs

Why do you need financing? Are you starting a new business, expanding an existing one, or covering operating expenses? How much money do you need? Ask these questions first so you can be specific about the amount you need to achieve your goals.

  • Step 2: Research Your Options

Consider traditional banks, online lenders, and the Small Business Administration (SBA). Each has its own advantages and disadvantages in terms of interest rates, fees, and eligibility requirements. Other than that, compare loan terms and pay attention to interest rates, repayment terms, and any prepayment penalties.

  • Step 3: Gather Your Documents

Gather essential business documents such as personal and business tax returns, business licences and permits, bank statements, business plans and financial projections.

  • Step 4: Submit Your Loan Application

Fill out the application form carefully and accurately and provide all required documentation.

  • Step 5: Wait for a Decision

The lender will review your application and make a decision. This may take a few days.
Once your loan is approved, you will receive the funds so you can begin making payments for all necessary business expenses.

5 Tips for Managing Business Finance Effectively

Following are some of the most important tips you need to keep in mind to manage and meaning of business finance effectively:

1.    Separate Business and Personal Finances
It is important to maintain a clear distinction between personal and business finances. This is crucial for tax purposes, documentation, and overall financial transparency. The recommendation is to open a business bank account for streamlined record-keeping.
2.    Pay Yourself a Salary
Small business owners need to prioritise paying themselves, even if it is a modest amount. This practice helps manage personal expenses and build personal savings, offering financial stability regardless of the business's success.
3.    Start with Required Financial Documents
There are three fundamental financial statements—balance sheet, profit and loss statement, and cash flow statement. These documents provide insights into the business's financial health, aiding in decision-making, assessing profitability, and managing cash flow effectively.
4.    Follow Accounting Best Practices
Distinct between cash and accrual basis accounting, outlining the pros and cons of each. It stresses the importance of selecting accounting software for efficient financial management, considering factors such as cloud access, customer support, and automation capabilities.
5.    Consider an Accounting Professional
It is recommended to work with an accounting professional to ease financial management tasks. This could involve creating a business plan, selecting the appropriate business entity, managing accounts payable, and applying for business loan. Outsourcing accounting tasks, especially in the early stages, is suggested to control costs.

4 Key Financial Ratios and Metrics

Following are the 4 key financial ratios and metrics you need to keep in mind when availing business financing:

1.    Working Capital Ratio
The working capital ratio assesses a company's liquidity, representing its ability to settle short-term obligations with current assets. Calculated as current assets divided by current liabilities, a ratio of 2 or higher indicates healthy liquidity, but excessive short-term assets may suggest underutilisation.
2.    Quick Ratio (Acid Test)
The quick ratio gauges liquidity by measuring a company's capacity to cover current liabilities with quickly convertible assets. The formula, excluding inventory and prepaid expenses, is (current assets - inventory - prepaid expenses) / current liabilities. A quick ratio below one may indicate insufficient liquid assets, necessitating capital raising or other actions.
3.    Debt-to-Equity Ratio
The debt-to-equity ratio evaluates a company's reliance on borrowed funds to fund operations. Calculated as total liabilities divided by total shareholders' equity, a lower ratio is generally favourable. However, industry norms and company-specific considerations should guide the analysis.
4.    Return on Equity (ROE)
ROE measures a company's profitability and efficiency in using shareholder equity to generate profits. Calculated as net income divided by total shareholders' equity, a higher ROE signifies the effective use of equity for profit generation. Consideration of industry benchmarks is essential for meaningful interpretation.

To Conclude

Understanding the meaning of business finance is the heart of any business. However, at times, it can be hard to find financing for a business. If you’re looking for MSME loan, then consider taking out a collateral-free Business Loan or a Working Capital Loan. You can avail of such loans entirely online through a hassle-free process and even take advantage of flexible repayment tenures.

 

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Business Loan disbursal is at the sole discretion of Poonawalla Fincorp.
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poonawalla fincorp team

Poonawalla Fincorp Team

Our team of expert writers and editors are passionate about providing authentic and valuable information on finance. Our aim is to simplify financial and finance-related concepts. We strive to help our readers become more aware and empowered to make informed financial decisions.

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