business finance uf

business finance uf

The Fundamentals of Business Finance: Understanding and Applying Key Concepts

1. Introduction to Business Finance

“Value creation” is a very powerful concept. Companies that do not consistently create value for their customers often do not survive in the long term. Good, sustainable cash flow and return on investment are strong indicators that a company is doing a good job in creating value for their customers. In effect, doing a good job for customers results in doing a good job for businesses.

As Chapter 1 explains, finance is an integral part of business, where the business and finance process never stops. Profits from sales of products or delivery of service usually are directed at two main goals – cash flow and return on investment. Every business needs cash to pay its bills on time. In addition, a business not only has an obligation to generate profits for itself, but also is accountable to shareholders. The bottom line is what investors really look at, although financial managers and investors use a great variety of accounting and financial reports in order to understand how the bottom line is derived and what affects the bottom line.

2. Financial Statements and Analysis

Analysis of financial statements gives information on liquidity, solvency, and profitability of the company. The liquidity of a business explains the company’s ability to settle its obligations. Being solvent means that the company’s total assets do not exceed its total liabilities. Finally, profitability pertains to the company’s capacity to yield profits. Moreover, financial statements can be analyzed through various tools such as common-size analysis, ratio analysis, and trend analysis. The common-size financial statement allows for the comparison between companies with various sizes. Ratio analysis uses financial ratios to measure a company’s financial performance. Trend analysis reviews a company’s financial performance over time to identify trends. Although trend analysis describes financial trends, it does not explain why the company experiences such trends. Information on financial performance may be affected by several factors such as the industry in which the company operates, the size of the business, and conditions in the economy as a whole.

Business finance contains various financial terms that are quite important, such as financial statements, cash flow, and finances. Financial statements are official records of the activities of a business, individual, or entity. There are four types of financial statements that include the balance sheet, income statement, cash flow statement, and the statement of shareholders’ equity. The balance sheet shows the company’s assets, liabilities, and the proprietor’s (or shareholder’s) equity achieved at the end of an accounting period. The income statement shows the company’s expenses and income received over a period of time. The cash flow statement is a financial report that shows the inflow and outflow of cash over a specific accounting period. The statement of shareholders’ equity is a financial report that enlists the changes in total equity of the business over a specific accounting period.

3. Capital Budgeting and Investment Decisions

When choosing a capital budget decision-making process, a company wants to identify the individual projects that are worth more than they cost, and then finance those acquisitions with a weighting of different classes of financial assets and liabilities so that the overall risk minimizes the weighted average cost of capital. In an efficient market, capital budgeting decisions will be implemented by investors through a balanced portfolio of risky assets held either in the form of stocks or corporate or mortgage bonds to maximize a company’s intrinsic value.

Capital budgeting is the process by which a company decides whether or not to acquire assets and the method to use to finance the acquisition. The investment decisions are generally the most important aspects of most financial decisions. In total, U.S. companies make about $425 billion worth of capital budgeting decisions each year. In 2010, Procter & Gamble spent over $2 billion to introduce the Swiffer WetJet after spending five years developing it. In the same year, Fiat used almost $1 billion to acquire about 7% of Chrysler Group, while Deere & Co. increased capital spending from $0.3 billion to almost $4 billion to expand its overseas production.

4. Risk Management and Financial Markets

The concept of managing risks to the company’s future cash inflows becomes the major introductory aspect of our discussion of the financial futures and options markets. However, please recognize that the risks in these markets are enormous. While it’s true that profits in these financial markets have proved to be many times the profits available from the goods markets, it’s also true that the probable losses are impossible for a normal person to imagine. The profits are clearly attendant to the risks of these very volatile markets. Consequently, it’s crucial that a company’s Board of Directors or a bondholder or any other stakeholder truly understands the nature of these risks to appreciate the importance of using these markets and, more importantly, the determination and fortitude necessary for carrying off these protection strategies.

Risk management is a major part of any company’s operations. Risk management means a company has identified possible risks, analyzed each risk, and planned strategies for dealing with them. The most common risks are natural disasters, such as hurricanes and earthquakes. In addition to these natural risks, companies must also deal with financial risks. These financial risks are risks not only to the company as an organizational entity but financial risks that affect the shareholders, bondholders, and other stakeholders of the company. Financial risks include changes in interest rates as well as changes in exchange rates if the company does business internationally. One basic approach to ensuring that a company’s future cash inflows are secure is for the company to enter into futures or option contracts today to fix the amount of cash inflows the company will receive in the future while shielding the company from currency and interest rate fluctuations. In today’s environment of major currency fluctuations and brutally fast swings in interest rates, this is an extremely important decision.

5. Ethical Considerations in Business Finance

In the first example, a manager may be highly motivated by a large bonus if the investment proposal is accepted. The manager also recognizes that the investment proposal is close to what management believes the typical decision-maker is willing to accept. Therefore, the manager may inflate the estimated benefits the organization will receive and lower the anticipated costs, resulting in inflated net benefits. The temptation to conduct this manipulation is not an ethical business practice. Not only does the proposed investment represent a greater risk because it may not have enough benefits to justify its costs, but also the manager is failing to fulfill a responsibility to the organization and its shareholders. Including the ethical considerations of honesty and fairness in financial decision-making will help ensure that decisions are consistent with the organization’s overall goals.

Organizations must make ethical financial decisions that consider both sound financial principles and a sense of responsibility. Ethically responsible management in financial decision-making areas is based on honesty and integrity. An organization has a responsibility to act ethically and to operate in a way that positively affects its stakeholders, such as employees, customers, and the communities it serves. Ethical behavior in business finance is characterized by honesty and fairness. Two examples of ethical considerations in business finance are avoiding the temptation to manipulate the results of an investment proposal in order to increase the likelihood of approval and adhering to accounting practices that may be more conservative than legally required.