How to Finance a Business: Everything You Need to Know

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By: Site Engineer, Staff

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For any businessman, one area of particular concern lies in the effective management of financial matters, the sources, and uses of funds.

Small businesses generally have a weak capital base since the majority of them are to draw money from the capital market as big companies do. Consequently, the only option is to borrow money and often times on unfavorable terms. Small businesses rely primarily on ‘own equity, bank financing, trade credit’ and lease financing to finance their business.

However, in recent years small-scale industries in Nigeria are being given increasing policy attention and financial incentives. But before going into sources of finances it is important that the potential investor has an idea of an estimated level of fund needed for his particular type of business. He needs to count how much money for his own (equity) he is prepared to put into the business before he thinks of borrowing and to seek for other financial assistance. This requires proper budgeting to help ensure that proper control and evaluative procedures are established in a business because it is a valuable tool for planning.

The budget can be prepared by small business to cover any period of time desired by the business owner, and the level of cost differs depending on the type of business.

The Definition and Functions of Finance

Finance which has evolved as a field of study and as one of the functional areas of management is concerned with the techniques of raising and allocation of funds with a view to maximizing the wealth of individuals, corporate bodies, communities, and nations.

The term funds which can also be substituted with finance refer to all forms of money or near monies and they include cash and non-cash assets with varying degrees of liquidity. The non-cash assets include debts, equity, and debt certificates.

Finance as a field of study is divided into public finance which deals with sources of government revenue and how it spends it, and private finance for individuals and corporations. Private finance involves raising of funds and their allocation within a firm in order to maximize shareholder’s wealth.

Finance Has Three Major Functions:

  • Investment Decision: This deals with the allocation of funds to acceptable investment proposals. The study of finance enables one to identify, appraise and rank investment opportunities in form of projects with a view to allocating available funds to such projects.
  • Financing Decision: This deals with the best way of sourcing funds within the framework of an optimal capital structure with a view to minimizing the cost of capital and thereby maximizing investment returns.
  • Dividend Decision: Benefits from the use of funds have to be distributed to those who supplied them and these include ordinary shareholders, preference shareholders and creditors or bondholders. Those assigned with the responsibility of managing corporations have to be informed and educated in matters related to dividend decision. This decision is one of the most political decisions they have to make; moreover, it is a decision that involves outsiders.

Definition and Scope of Investment

An investment can simply be defined as an allocation of existing economic activities to which funds are allocated.

Examples of these activities are:

  • Purchase of treasury bills in the money market.
  • Purchase of fixed assets such as a printing machine
  • Expenses meant to promote the image and goodwill of an enterprise.
  • Venturing into a new business such as irrigation or photography.
  • Expanding an existing business or opening a new branch.
  • Replacement of worn-out assets.
  • Purchase of shares and bonds in the capital market.

Investment returns tend to have a positive correlation with investment risk. This means the higher the returns the higher the risks. The returns are more often than not, seen in terms of income or profit but there are other forms of return or reasons for making investments. Some investments are made for capital gain which implies capital appreciation. Some are for the security of capital while others are for social recognition and political or moral reasons.

The Relationship Between Finance and Investment

From the definition of finance and investment, it could be seen that the latter is part and parcel of the former. We have seen that investment decision is one of the major functions of finance, so we cannot separate investment from finance. That is why some major topics in financial management or theory of finance also feature in investment analysis. These topics include capital budgeting techniques, valuation of securities and portfolio management.

Identification of Investment Opportunities

An investment opportunity is characterized by the followings:

  • The potential investor’s capacity to satisfy potential consumers.
  • The existence of a consumer’s unsatisfied or partially satisfied needs and wants.
  • The needs and wants have to be sufficient enough to make the investment profitable.

Investment opportunities can be identified from the following sources:

  • Study of published research reports trade journals annual statistical reports and trade catalogs from embassies and multinational corporations.
  • Personal experiences of an investor g., an experience from previous employment.
  • Investor’s hobbies and part-time activities.
  • Existing patent rights and licenses.
  • Consultation with friends, business acquaintances public and private consultants.
  • An investor can brainstorm in order to come up with an investment opportunity that is entirely new.
  • Trade fairs and exhibitions.
  • Imitation of existing investors.

Investment Risks

Certainty, Uncertainty, and Risk

Investment decisions are carried out under three environmental conditions these are the conditions of certainty, uncertainty, and risk.

The condition of certainty prevails where an investor has full knowledge of the ultimate outcome of an investment. He plans to make in the future this however a very rare conditions an investment in government treasury bills provides a good example of investment decisions made under this condition.

The condition of uncertainty exists when an investor is ignorant about the future outcome of an investment or the probability of its occurrence. Uncertainty is a subjective phenomenon because two or more individuals are unlikely to have identical views of the outcome or decisions taken under conditions of uncertainty.

The condition of risk exists between the two extremes, under it, an investor has incomplete knowledge as well as incomplete ignorance about the future outcome of an investment.

The risk is defined as “a situation where the parameters of the probability distribution of outcomes are known”. This suggests that under conditions of risk an investor knows the possible consequences of investment decisions, in other words, he knows the probability distribution of the future outcomes of investments.

Types of Risks

There are many factors which contribute to the variability of the possible returns of an investment. Some of the influences are external to the investor and are largely beyond his control; they are referred to as sources of systematic risk. Other influences are interns! And are to a large extent controllable, they are called the elements of unsystematic risk. It can, therefore, be said that investment risk is made up of two main parts the systematic and the unsystematic risk.

The systematic risk is the portion of the total variability of investment returns caused by factors that affect all investments. It is also called market risk. The factors that cause it to include economic and political factors.

The unsystematic risk is the portion of the total variability in investment returns caused by factors that are unique to the investment for the firm or industry.

The components of investment risk generally include the followings:

  • Business Risk: This arises from a change in economic conditions which lead to an unexpected decline in earnings.
  • Market Risk: This comes from adverse market reaction (i.e customer reaction) to events like religious and ethnic crises and natural disasters which are not anticipated by business.
  • Purchasing Power Risk: This arises from a fall in the real value of investment outcomes due to an unanticipated increase in the rate of inflation.
  • Political Risk: This arises from the non-predictability of political forces, which affect the investment outcome. The forces include indigenization and nationalization policies of governments.
  • Risk of Unplanned Obsolescence: This occurs when economic or technological factors that are never anticipated which leads to premature abandonment of a product line of an entire project.
  • Management and Labor Union Risk: Management risk arises from unanticipated variation in the company’s profit performance due to management’s errors of judgment fraud etc. Labor unions strikes and sit-ins also contribute to this risk.

The riskiness of an investment proposal is the variability of its possible returns. The greater the magnitude of deviation from the expected value and the greater the magnitude of its occurrence the greater will be the risk of an investment. The more the values of the individual outcomes are clustered around the expected value the smaller the risk of investment.

 

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