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What is Finance ? | Definition, Types, Sources & Features


Contents :                                  

  • Meaning and Definitions of Finance.
  • Various Features of Finance.
  • Types of Finance.
  • Internal and External Sources of Finance.

What is Finance ?

Finance is the soul of economic activities. To perform any economic activity, certain resources are needed which are to be pooled in terms of money (i.e. in the form of currency notes, other valuables, etc.). Finance is a prerequisite for obtaining physical resources, which are needed to perform productive activities and carrying business operations such as sales, pay compensations, reserve for contingencies (unascertained liabilities) and so on.

Meaning of Finance 

Finance plays a very important role in making an organisation successful and it is a starting point of every business activity. Finance is regarded as science as well as an art. It is the soul of every business and basic requirement for starting and running business. Business finance is the lifeblood of business. There must be continuous flow of funds in and out of a business enterprise. Finance makes the wheels of business to run smoothly. In these modern days, finance is one of the foundations of economic activity of mankind.

Definitions of Finance by Authors 

Business finance is really a very broad concept. It relates to all the financial activities of the business. Business finance has been defined by various authorities as follows:

Howard and Upton :
"Finance is that administrative area or set of administrative functions in an organisation which relate the arrangement of cash and credit so that the organisation may have the means to carry out its objectives as satisfactorily as possible".

E. W. Paish :
"It is a modern money using economy, finance may be defined as the provision of money at the time it is required".

Bonneville and Deway :
"Business finance consists of the raising, providing, managing of all the money, capital or funds of any kind to be used in connection with the finance".

Guthmann and Dougall :
“Business finance can be broadly defined as the activity concerned with planning, raising and administering of funds used in the business".

Features of Finance 

The main characteristics or features of finance are depicted below.

1) Investment Opportunities :
In Finance, investment can be explained as an utilization of money for profit or returns. Investment can be done by :
  • Creating physical assets with the money (such as development of land, acquiring commercial assets, etc.).
  • Carrying on business activities (like manufacturing, trading, etc.).
  • Acquiring financial securities (such as shares, bonds, units of mutual funds etc.).
  • Investment opportunities are commitments of monetary resources at different times with an expectation of economic returns in the future.

2) Profitable Opportunities :
In Finance, Profitable opportunities are considered as an important aspiration (goal). Profitable opportunities signify that the firm must utilize its available resources most efficiently under the conditions of cut-throat competitive markets. Profitable opportunities shall be a vision. It shall not result in short-term profits at the expense of long-term gains. For example, business carried on with non-compliance of law, unethical ways of acquiring the business, etc., usually may result in huge short-term profits but may also hinder the smooth possibility of long-term gains and survival of business in the future.

3) Optimal Mix of Funds :
Finance is concerned with the best optimal mix of funds in order to obtain the desired and determined results respectively. Primarily, funds are of two types, namely,
  • Owned funds (Promoter Contribution, Equity shares, etc.).
  • Borrowed funds (Bank Loan, Bank overdraft, Debentures, etc).
The composition of funds should be such that it shall not result in loss of profits to the Entrepreneurs (Promoters) and must recover the cost of business units effectively and efficiently.


4) System of Internal Controls :
Finance is concerned with internal controls maintained in the organisation or workplace. Internal controls are set of rules and regulations framed at the inception stage of the organisation, and they are altered as per the requirement of its business. However, these rules and regulations are monitored at various intervals to accomplish the same which have been consistently followed.

5) Future Decision Making :
Finance is concerned with the future decision of the organisation. A "Good Finance" is an indicator of growth and good returns. This is possible only with the good analytical decision of the organisation. However, the decision shall be framed by giving more emphasis on the present and future perspective (economic conditions) respectively.

6) Acquisition, Allocation & Utilization of Funds :
Finance as a function deals with acquisition, allocation and utilization of funds. A business must ensure that adequate funds are available from the right sources at the right cost at the right time. It needs to decide the mode of raising fund, whether it is to be through the issue of securities or lending from the bank. Once funds are acquired the funds have to be allocated to various projects and services and finally the objective of the business is to earn profits which on a very large extent depend upon how effectively and efficiently allocated funds are utilized. Proper utilization of funds is based on sound investment decisions, proper control and asset management policies and efficient management of working capital.

7) Maximization of Shareholder's Wealth :
The objective of any business is to maximize and create wealth for the investors, which is measured by the price of the share of the company. The price of the share of any company is a function of its present and expected future earnings, Finance helps in defining policies and ways to maximize the earnings

Maximization of economic welfare of its owners is the accepted financial objective of the firm. Hence, the objectives of finance are to ensure adequate and regular supply of funds to the business and provide a fair rate of return to the suppliers of capital. Finance helps by ensuring efficient utilization of capital and available resources according to the principles of profitability, liquidity and safety. It provides a definite system for internal investment, financing and internal controls. And finally attempts to minimize cost of capital by developing a sound and economical combination of corporate securities.

9) Channelizing of Funds :
It is well established fact that financial system is a critical element of any economy. Financial sector and financial markets perform the essential function of channeling funds from people who have saved surplus funds by spending less than their income to people who have a shortage of investible funds because their plans to spend exceed their income.


Types of Finance 

Finance can be broken into three different sub categories: public finance, corporate finance and personal finance. All three of which would contain many sub-categories.

1) Public Finance :
Public Finance is a part of study of Economics. It borders on the fields of government and political science. Public finance is the study of the financial activities of governments and public authorities. Public finance describes finance as related to sovereign states and sub-national entities (like states/provinces) and related public entities (e.g. municipal corporations) or agencies. It describes and analyses the expenditures of governments and the techniques used by governments to finance these expenditures. It is concerned with the identification of required expenditure of a public sector entity and sources of revenue and the budgeting process. Public finance analysis helps us to understand why certain services have come to be supplied by government, and why governments have come to rely on particular types of taxes.

2) Business/ Corporate Finance :
Corporate finance is the task of providing the funds for a corporation's activities by raising and administering funds. Corporate finance aims at studying the funding of assets from various sources like market, general public, or various financial institutions. In this process corporate finance aims to balance risk and profitability, while attempting to maximize an entity's wealth and the value of its stock. The importance of corporate finance is underlined by economic and social significance in terms of increase in public responsibility as the organization grows and wide distribution of the corporate ownership in the process separating ownership from management.

3) Personal Finance :
Personal finance refers to the financial decisions which an individual must make to plan for his future. These decisions include obtaining monetary resources, planning application of income, budgeting, deciding on amounts and mode of saving, and decisions around spending monetary resources over time. During this process one is expected to take into account various financial risks and future life events that may impact current income levels or projected incomes and must plan for them.

i) Direct Finance :
In this case the borrower directly borrow funds from the lender in the financial markets by selling them securities (also called financial instruments), which are claim on the borrower's future income/assets or reserves and entitle the borrower with partial ownership if the funds have be raised using equity.

ii) Indirect Finance :
In this case the role of channelizing the funds from the savers to borrowers is done through financial intermediaries (example commercial banks).

iii) Long Term Finance :
Long term finance is generally used for investment in fixed assets such as land and building, plant and machinery etc. and is not repayable with in short period of time.

iv) Short Term Finance :
Short term finance is used for investment in working capital. It is used to meet the short term needs of the business. It may be repayable in short term or on demand as in case of a cash credit account. Short term loans are usually repayable within a period of one to three years

Internal and External sources of Finance 

A) Internal Sources :

The main internal sources of finance for a start-up are as follows:

1) Personal Sources :
These are the most important sources of finance for a start-up.

i) Retained Profits :
This is the cash that is generated by the business when it trades profitably - another important source of finance for any business, large or small. Note that retained profits can generate cash the moment trading has begun.
A start-up sells the first batch of stock for Rs.5000 cash which it had bought for Rs.2000. That means that retained profits are Rs.3000 which can be used to finance further expansion or to pay for other trading costs and expenses.

ii) Share Capital - Invested by the Founder :
The founding entrepreneur (/s) may decide to invest in the share capital of a company, founded for forming the start-up. This is a common method of financing a start-up. The founder provides all the share capital of the company, retaining 100% control over the business. The advantages of investing in share capital are covered in the section on business structure. The key point to note here is that the entrepreneur may be using a variety of personal sources to invest in the shares once the investment has been made it is the company that owns the money provided. The shareholder obtains a return on this investment through dividends (payments out of profits) and/or the value of the business when it is eventually sold.

B) External Sources :

A start-up company can also raise finance by selling shares to external investors - this is covered further below :

1) Loan Capital :
This can take several forms, but the most common are a bankloan or bankoverdraft. A bank loan provides a longer-term kind of finance for a start-up, with the bank stating the fixed period over which the loan is provided (e.g. 5 years), the rate of interest and the timing and amount of repayments. The bank will usually require that the start-up provide some security for the loan, although this security normally comes in the form of personal guarantees provided by the entrepreneur. Bank loans are good for financing investment in fixed assets and are generally at a lower rate of interest that a bank overdraft. However, they don't provide much flexibility.

2) A Bank Overdraft :
A Bank Overdraft is a more short-term kind of finance which is also widely used by start-ups and small businesses. An overdraft is really a loan facility the bank lets the business "owe it money" when the bank balance goes below zero, in return for charging a high rate of interest. As a result, an overdraft is a flexible source of finance, in the sense that it is only used when needed. Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time). Two further loan-related sources of finance are worth knowing about.

3) Share Capital- outside Investors :
For a start-up, the main source of outside (external) investor in the share capital of a company is friends and family of the entrepreneur. Opinions differ on whether friends and family should be encouraged to invest in a start-up company. They may be prepared to invest substantial amounts for a longer period; they may not want to get too involved in the day-to-day operation of the business. Both of these are positives for the entrepreneur. However, there are pitfalls. Almost inevitably, tensions develop with family and friends as fellow shareholders.

4) Business Angels :
Business angels are the other main kind of external investor in a start up company. Business angels are professional investors who typically invest £10k - £750k. They prefer to invest in businesses with high growth prospects. Angels tend to have made their money by setting up and selling their own business-in other words they have proven entrepreneurial expertise. in addition to their money, Angels often make their own skills, experience and contacts available to the company. Getting the backing of an Angel can be a significant advantage to a start-up, although the entrepreneur needs to accept a loss of control over the business.

5) Venture Capital :
Venture Capital mentioned as a source of finance for start-ups. Need to be careful here. Venture capital is a specific kind of share investment that is made by funds managed by professional investors. Venture capitalists rarely invest in genuine start-ups or small businesses (their minimum investment is usually over £1m, often much more). They prefer to invest in businesses which have established themselves. Another term you may here is "private equity" this is just another term for venture capital.A start-up is much more likely to receive investment from a business angel than a venture capitalist.

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