FINANCE & BANKING 21BSO662

Module-4 Financial Management

Meaning of finance – Business finance, Importance of business finance - Financial

requirements- working Capital requirements and fixed capital requirements

Meaning of finance

Finance is defined as the management of money and includes activities such as investing,
borrowing, lending, budgeting, saving, and forecasting. There are three main types of finance:
(1) personal, (2) corporate, and (3) public/government.

• Finance is a term that broadly describes the study and system of money, investments,
and other financial instruments.

• Finance can be broadly divided into three categories: public finance, corporate finance,
and personal finance.

• Subcategories of finance include social finance and behavioral finance.

• The history of finance and financial activities dates back to the dawn of civilization.

• Finance has roots in scientific fields such as statistics, economics, and mathematics but
it also includes non-scientific elements that liken it to an art.

Types of Finance

Finance is broadly categorized into 3 categories: personal finance, public finance, and
corporate (or business) finance.

1. Personal Finance

Personal finance refers to managing an individual’s monetary resources across 5 key areas:
Income, savings, investments, spending decisions, and asset protection. The goal is to make
intelligent investment decisions and build a safety net and meet their goals without taking on
too many debt obligations.

A personal financial system can also involve generational wealth transfer, taking advantage of
tax planning opportunities, filing tax returns, using credit cards, and buying, selling, and
managing assets. Personal finance is always tailored to one’s specific needs in the short,
medium, or long term.
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This means that two people may not make the same financial decisions because of their
different goals, earning potential, incomes, and timeframes. When it comes to managing your
finances, it’s important to set both short-term and long-term goals. For instance, you may want
to prioritize paying off a loan in the short-term, while also considering long-term investments
in real estate or the stock market. Personal finance software can be a helpful tool to assist you
with modern financial management.

Business owners must develop a strategic personal finance plan to protect them from
unforeseen circumstances. For example, having personal savings may help you raise startup
capital for your business, and saving for retirement helps the business owner avoid running out
of money and being forced to sell the business.

2. Public Finance

Like individuals, governments must allocate their resources to different sectors of the economy.
Public finance is how federal, state, and local institutions track revenue and manage expenses
for all the services they provide to the public.

Some of a government’s most essential functions include collecting money from the public
sector via taxes, raising capital through bonds, and channeling money into a broad range of
services that benefit the public. When the public sector distributes tax revenues across multiple
functions, including debt servicing, infrastructural development, and recurring expenditures.
By overseeing income generation and government spending, government agencies help ensure
a stable economy and prevent market failure.

Other aspects of public finance include tax management, debt issuance, budgeting,
international trade, and inflation regulation. These factors have a direct and lasting effect on
business and personal finance.

3. Business Finance (Corporate Finance)

Business finance, or corporate finance, covers all the financial activities related to running a
business. You can think of this in terms of acquisitions and investments, funding, capital
budgeting, risk management, and tax management needed for business growth in financial
markets.

Companies must balance cash flow, risks, and investment opportunities to increase their value
and strengthen their capital structure.
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A great example of corporate finance is when a business chooses between equity financing and
debt financing to raise capital. Equity financing is the act of securing funding through stock
exchanges and issues, while debt finance is a loan that must be repaid with interest on an agreed
date.

Businesses have to develop a revenue-generation plan which determines business profitability

in the medium- and long term.

Business Finance

Business finance refers to the management of financial resources within an organization to

achieve its objectives. Business finance encompasses the processes, strategies, and tools that
businesses use to make financial decisions, manage resources, and achieve their financial goals.
Business finance involves planning, directing, organizing, and controlling the financial
activities of a business. Essentially, business finance is the backbone of any successful
enterprise, providing the necessary foundation for growth and sustainability.

Business finance refers to the money and credit required by businesses to carry out their
activities.
It involves raising, managing, and utilizing funds in such a way that the business can operate
smoothly, grow, and achieve its objectives.

In short, business finance = money needed for business operations + financial decision-making.

The Importance of Business Finance

Strategic Decision-Making: Business finance is crucial for making informed and strategic
decisions within a company. Financial data, such as budgeting, cash flow analysis, and financial
forecasting, provides insights into the overall health and performance of the business. These
insights help leaders make informed decisions about investments, expansions, cost-cutting
measures, and other strategic moves that can impact the long-term success of the company.

Resource Allocation: Business finance plays a key role in efficient resource allocation. It helps
in determining how much capital is needed for various business activities, including acquiring
assets, hiring personnel, and funding operations. Effective resource allocation ensures that a
company uses its financial resources wisely, optimizing productivity and maximizing returns.
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Proper budgeting and financial planning contribute to the sustainability and growth of the
business.

Risk Management: Managing financial resources is essential for mitigating risks and
uncertainties in the business environment. Business finance helps in identifying and analyzing
potential risks, allowing the company to implement strategies to minimize their impact. This
includes having sufficient working capital to cover unforeseen expenses, creating financial
reserves, and utilizing insurance or hedging mechanisms. By addressing financial risks,
businesses can enhance their resilience and adaptability in the face of economic fluctuations
and market challenges.

Starting a Business: A business needs funds to set up infrastructure — buying land,

constructing buildings, purchasing machinery, setting up offices, and buying furniture.
Finance is required for legal formalities like company registration, licensing, and initial
marketing. Right from the beginning, businesses need to hire skilled staff, and salaries must be
paid, even before the company starts earning profits. Funds are also needed for buying raw
materials and maintaining inventory to kickstart production or service delivery. No business
can start without strong financial backing to cover these early expenses.

Running Daily Operations: Businesses need regular cash flow to pay for salaries, rent,
electricity, water bills, transportation, and raw material purchases. Finance is needed to keep
an adequate stock of goods to meet customer demand without delays. Sometimes, businesses
sell goods on credit but still have immediate expenses to cover — so finance bridges this cash
gap. Machinery, equipment, and technology need ongoing maintenance and upgrades, which
again need steady funding. Without finance, daily business activities could stop, leading to
losses and customer dissatisfaction.

Business Expansion: Businesses aiming to open new branches, expand to new markets,
increase production capacity, or add new product lines need significant financial investment.
To stay competitive, businesses need funds to adopt modern technologies, which require
upfront and ongoing investments. Expansion often needs hiring new staff, training them, and
investing in their well-being — all of which need finance. Finance acts as a growth fuel, helping
companies take strategic moves towards becoming bigger and more successful.

Facing Uncertainties: During recessions, businesses may see falling sales and profits. Having
reserve finance helps them survive these periods without shutting down. Natural disasters,
supply chain disruptions, lawsuits, or sudden repair costs can arise anytime — finance acts as
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a safety net. To react quickly to competition (new marketing campaigns, discounts, new product
launches), immediate funds may be required. Strong financial management ensures that the
business stays resilient even when unexpected challenges hit.

Innovation: Creating and testing new products needs research, market studies, prototypes, and
promotional campaigns — all of which require significant funding. Implementing new
software, automation tools, or AI systems helps improve productivity but needs upfront
investment. Innovative companies regularly invest in R&D to improve existing products and
develop next-generation solutions, keeping them ahead of the competition. Many businesses
invest in eco-friendly processes and technologies to appeal to modern, environmentally
conscious consumers — again needing finance. Finance promotes continuous innovation and
helps businesses stay relevant, efficient, and competitive in a fast-changing market.

Sources of Business Finance

Businesses have various sources of finance to choose from, each with its advantages and
considerations. Here are some common sources:

Equity Financing

Equity financing involves raising capital by selling ownership shares in a business. This can
come from angel investors, venture capitalists, or even through an initial public offering (IPO).
While equity financing does not require repayment, it means relinquishing a portion of
ownership and potential control of the business.

Debt Financing

Debt financing involves borrowing funds that must be repaid with interest over a specified
period. This can be in the form of bank loans, bonds, or other debt instruments. While it allows
businesses to retain ownership and control, it comes with the obligation to make regular interest
and principal payments.

Internal Sources

Internal sources of finance come from within the business. This includes retained earnings,
where profits are reinvested in the company, and personal savings of the business owner. While
internal sources offer independence and flexibility, they may not be sufficient for large-scale
projects.

External Sources
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External sources involve obtaining funds from outside the business. This can include loans
from financial institutions, investments from external partners, or government grants. External
sources provide additional capital but may come with conditions or interest payments.

Types of Business Finance

Understanding the various types of business finance is crucial for tailoring financial strategies
to the specific needs of a business.

Short-Term Finance

Short-term finance addresses immediate financial needs and typically has a repayment period
of one year or less. It is often used for working capital requirements, such as paying suppliers,
meeting payroll, or handling unforeseen expenses. Short-term finance options include trade
credit, bank overdrafts, and short-term loans.

Long-Term Finance

Long-term finance involves securing funds for projects or investments with a longer time
horizon, usually exceeding one year. This type of finance is suitable for significant capital
expenditures, such as purchasing real estate, expanding production capacity, or launching new
products. Long-term finance options include equity financing, bonds, and term loans.

Internal Finance

Internal finance is generated from within the business without external borrowing. It includes
retained earnings, where a portion of profits is reinvested in the company, and depreciation
funds, which set aside money for replacing assets. Internal finance offers autonomy and
flexibility but may be limited in scale.

External Finance

External finance involves obtaining funds from sources outside the business. This can include
loans from financial institutions, investments from venture capitalists, or public offerings of
stocks. External finance provides additional capital but may come with interest payments,
dilution of ownership, or other obligations.

Project Finance

Project finance is a specialized form of financing used for large-scale projects with distinct
cash flows. It involves creating a separate legal entity for the project and securing financing
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based on its anticipated revenue. Project finance mitigates risks by isolating the project's
financial structure from the overall business.

How to Manage Finance for Business/ Key steps to ensure sound financial
management

Effectively managing finance is essential for the sustained growth and success of a business.
Here are key steps to ensure sound financial management:

Understand Business's Financial Needs

Before devising a financial strategy, it's crucial to understand the specific financial needs of
your business. This includes identifying short-term and long-term goals, estimating operating
expenses, and determining the capital required for growth initiatives.

Develop a Comprehensive Budget

A well-structured budget is the cornerstone of effective financial management. It outlines

anticipated revenues, planned expenses, and investment allocations. Regularly review and
adjust the budget as needed to align with changing business conditions.

Monitor Cash Flow

Cash flow is the heartbeat of a business. Monitor and manage cash flow by tracking the
movement of money into and out of the business. This involves staying on top of accounts
receivable, accounts payable, and other key financial metrics.

Diversify Funding Sources

Relying on a single source of funding can expose your business to risks. Diversify your funding
sources to include a mix of equity and debt financing, internal funds, and external investments.
This not only provides financial stability but also enhances your ability to weather economic
uncertainties.

Invest Wisely

Carefully evaluate investment opportunities to ensure they align with your business objectives.
Whether it's expanding operations, upgrading technology, or launching new products,
investments should contribute to the long-term success of the business.

Build a Financial Cushion

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Unforeseen circumstances can impact your business at any time. Building a financial cushion
or reserve helps buffer the business against unexpected expenses, economic downturns, or
other challenges. This reserve provides a safety net to keep operations running smoothly during
turbulent times.

FINANCIAL REQUIREMENTS

Financial requirements refer to the amount of funds needed by a business to carry out its
operations smoothly and to meet its short-term and long-term objectives. They are broadly
classified into:

1. Fixed Capital Requirements

2. Working Capital Requirements

Fixed Capital Requirements

Fixed capital requirements refer to the funds needed for long-term assets like property, plant,
and equipment, while working capital requirements are for short-term needs like day-to-day
operations. Fixed capital investments are typically financed through long-term sources like
equity or long-term debt, whereas working capital is often financed through short-term loans
or trade credit.

Fixed capital is the part of a company's total capital invested in long-term assets, such as land,
buildings, machinery, and equipment. These assets are intended to be used for more than one
accounting period and are not for sale in the ordinary course of business.

• Examples:

• Purchase of land or buildings.

• Acquisition of machinery or equipment.

• Investment in research and development.

Fixed capital investments are typically funded through long-term sources like equity, long-term
loans, or retained earnings.

Fixed capital is the capital required to acquire fixed assets that are used over the long term to
generate income for the business.

Characteristics:
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• Long-term in nature

• Invested in non-current assets

• Not converted into cash during normal business operations

• Essential for the infrastructure of the business

Management of Fixed Capital

Raising fixed capital required by the firm at minimum cost and using it effectively sums up
the management of fixed capital. The decision taken by a firm to invest in fixed assets is
known as Capital Budgeting Decision. A firm must take capital budgeting decisions
carefully as it affects the profitability, growth, and risk of business in the long run. It consists
of decisions related to the purchase of land, plant and machinery, building, investing in
advanced techniques of production, or launching a new product line.
A firm must always finance its fixed assets through long-term sources like shares, debentures,
long-term loans, etc., and not through short-term sources.

Factors Affecting Requirement of Fixed Capital

Fixed Capital refers to investment in fixed assets for a longer period. The fixed capital of an
organisation gets its funds through long-term sources of finance like preference shares, equity
shares, debentures, etc. The requirement of fixed capital in an organisation depends upon
various factors. These factors are as follows:

1. Nature of Business
The first factor which helps in determining the requirement of fixed capital is the type of
business in which the company is involved. A manufacturing company requires more fixed
capital, as compared to a trading company. It is because a trading company does not need
plant, machinery, equipment, etc.

2. Scale of Operation
The companies operating at a large scale require more fixed capital as compared to the
companies operating at a small scale. It is because the former requires more machinery and
other assets; however, the latter requires less machinery.

3. Technique of Production
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The companies that use capital-intensive techniques require more fixed capital; however, the
companies that use labour-intensive techniques require less fixed capital. It is because the
capital-intensive techniques use plant and machinery, which requires more fixed capital.

4. Growth Prospects
Companies aiming at expanding their business and having higher growth plans require more
fixed capital for expansion of business, they have to expand their production capacity and to
do so they need more plant and machinery. Hence, the companies aiming at expanding their
business require more fixed capital.

5. Technology Upgradation
Industries, where technology upgradation is fast, requires more fixed capital as whenever
new technology is invented, the old machines become obsolete and the firm has to purchase
new plant and machinery. However, the companies where technological upgradation is slow,
need less fixed capital as they can easily manage with old machines.

6. Diversification
The companies which are planning to diversify their activities by including more range of
products require more fixed capital. It is because, for diversification of the business, they
have to produce more products for which more plants and machinery are required, ultimately
increasing the need for more fixed capital.

7. Level of Collaboration/Joint Ventures

The companies that prefer collaborations or joint ventures need less fixed capital as these
companies can share plant and machinery with the collaborators. However, if a company
prefers to operate its business as an independent unit, then it will require more fixed capital.

8. Availability of Finance and Leasing Facility

If a company can easily arrange financial and leasing facilities, then it will require less fixed
capital, as it can acquire the required assets in easy instalments and won’t have to pay a huge
amount at one time. Whereas, if a company cannot find financial and leasing facilities easily,
then it will require more fixed capital, as it has to purchase plant and machinery by paying a
huge amount at once.

Working Capital Requirements

Working capital is the capital required for day-to-day operations of a business, such as
purchasing raw materials, paying wages, and managing inventories. Working capital refers to
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the funds needed to finance a company's day-to-day operations. It represents the difference
between a company's current assets (cash, inventory, accounts receivable) and its current
liabilities (accounts payable, short-term debts).

Examples:

• Paying for raw materials.

• Meeting payroll and other operating expenses.

• Funding inventory levels.

Financing:

Working capital is typically financed through short-term sources like short-term loans, trade
credit, or bank overdrafts.

Types:

• Gross Working Capital: Total current assets of a business.

• Net Working Capital: Current assets minus current liabilities.

Components of Working Capital:

• Cash and bank balances

• Inventory (raw materials, work-in-progress, finished goods)

• Accounts receivable (debtors)

• Prepaid expenses

• Short-term investments

Factors Affecting the Working Capital

1. Nature of Business
The first factor which helps in determining the requirement of working capital is the type of
business in which the company is involved. A trading company or a retail shop requires less
working capital as the length of the operating cycle of these types of businesses is small.
However, the wholesalers require more working capital as they have to maintain a large stock
and generally sell goods on credit, increasing the length of the operating cycle. Besides, a
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manufacturing company requires a huge amount of working capital as it has to convert its
raw material into finished goods, sell the goods on credit, maintain the inventory of raw
materials and finished goods.

2. Scale of Operation
The firms that are operating at a large scale need to maintain more debtors, inventory, etc.
Hence, these firms generally require a large amount of working capital. However, the firms
that are operating at a small scale require less working capital.

3. Business Cycle Fluctuation

A market flourishes during the boom period which results in more demand, more stock, more
debtors, more production, etc., ultimately leading to the requirement for more working
capital. However, the depression period results in less demand, less stock, fewer debtors, less
production, etc., which means that less working capital is required.

4. Seasonal Factors
The companies which sell goods throughout the season require constant working capital.
However, the companies selling seasonal goods require a huge amount of working capital
during the season as at that time there is more demand and the firm has to maintain more
stock and supply the goods at a fast speed, and during the off-season, it requires less working
capital as the demand is low.

5. Technology and Production Cycle

A company using labour-intensive techniques requires more working capital because it has
to maintain enough cash flow for making payments to labour. However, a company using
capital-intensive techniques requires less working capital because the investment made by
the company in machinery is a fixed capital requirement and also there will be less operating
expenses.

6. Credit Allowed
The average period for collection of the sale proceeds is known as the Credit Policy. The
credit policy of a company depends on various factors like the client’s creditworthiness,
industry norms, etc. A company following a liberal credit policy will require more working
capital, as it is giving more time to the creditors to pay for the sale made by the company.
However, if a company follows a strict or short-term credit policy, then it will require less
working capital.
7. Credit Avail
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The time period that a company is getting credit from its suppliers also affects the
requirement for working capital. If a company is getting long-term credit on raw materials
from its supplier, then it can manage well with less working capital. However, if a company
is getting short period of credit from its suppliers, then it will require more working capital.

8. Operating Efficiency
If a company has a high degree of operating efficiency then it will require less working
capital; however, if a company has a low degree of operating efficiency, then it will require
more working capital. (Operating cycle of a firm is the time period from the purchase of raw
material to the realisation from debtors). Hence, it can be said that the length of the operating
cycle directly affects the requirements of the working capital of an organisation.

9. Availability of Raw Materials

If the raw material is easily available to the firm and there is a ready supply of inputs and raw
material then the firm can easily manage with less working capital. Also, as the firm does not
need to maintain any stock of raw materials, they can manage with less stock, and hence less
working capital. However, if there is a rough supply of raw materials, then the firm will have
to maintain a large inventory to carry on the operating cycle smoothly. Therefore, the firm
will require more working capital.

10. Level of Competition

If there is competition in the market, then the company will have to follow a liberal credit
policy for supplying goods on time. For this, it will have to maintain higher inventories,
resulting in more working capital requirements. However, if there is less competition in the
market or a company is in a monopoly position, then it will require less working capital as it
can dictate its own terms according to its requirements.

11. Inflation
A rise in the price increases the price of raw materials and the cost of labour, resulting in the
increasing requirement for working capital. However, if a company is able to increase the
price of its goods also, then it will face less problem with working capital. A rise in price has
a different effect on the working capital of different businesses.

12. Growth Prospects

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If a firm is planning on expanding its activities, then it will require more working capital as
it needs to increase the scale of production for expansion, resulting in the requirement of
more inputs, raw materials, etc., ultimately increasing the need for more working capital.

Difference Between Working Capital and Fixed Capital Requirements

Basis Fixed Capital Working Capital

Capital required to acquire long- Capital needed for day-to-day

Definition
term assets business operations

Used to purchase fixed assets like Used for short-term needs like raw
Purpose
land, building, machinery materials, wages, utilities

Nature Long-term Short-term

Investment
One-time or infrequent investment Continuously required for operations
Period

Inventory, Accounts Receivable,

Examples Land, Plant & Machinery, Vehicles
Cash, Bills Payable

Liquidity Not easily converted into cash Easily converted into cash

Return on
Returns over the long run Generates quick returns
Investment

Higher risk due to large investment

Risk Involved Comparatively lower risk
and long-term nature

Equity, Long-term loans, Short-term loans, Trade credit, Bank

Sources
Debentures overdrafts

Applicable (as assets wear out over

Depreciation Not applicable
time)

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