Mountains of the Moon University

Lecture Notes for ENT 2204

Business Finance and Budgeting

UNIT ONE:
INTRODUCTION TO BUSINESS FINANCE: KEY DEFINITIONS AND
CONCEPTS

Content Outline:
1.1. Introduction to the Course
1.2. The Meaning of Business Finance
1.2.1. Key Functions of Business Finance
1.2.2. Business Finance Vs Other Business functions
1.2.3. The Objective of Business Finance
1.2.4. The Organisation of Businesses
1.2.5. Long-term Financing of Businesses
1.3.Summary
1.4. Practice Questions

1.1. INTRODUCTION TO THE COURSE

Businesses are, in effect, investment agencies or intermediaries. This is to say that their role is to
raise funds from various sources and to invest those funds. Usually, funds will be obtained from
the owners of the business (the shareholders) and from long-term lenders, with some short-term
finance being provided by banks (perhaps in the form of overdrafts), by other financial institutions
and by other businesses prepared to supply goods or services on credit (trade payables (or trade
creditors)).

Businesses typically invest in real assets such as land, buildings, plant and inventories (or stock),
though they may also invest in financial assets, including making loans to, and buying shares in,
other businesses. People are employed to manage the investments, that is, to do all those things
necessary to create and sell the goods and services that the business provides. Surpluses remaining
after meeting the costs of operating the business – wages, raw material costs and so forth – accrue
to the investors.

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Of crucial importance to the business will be decisions about the types and quantity of finance to
raise and the choice of investments to be made. Business finance is the study of how these
financing and investment decisions should be made in theory and how they are made in practice.

Business finance is a relatively new subject. Until the 1960s it consisted mostly of narrative
accounts of decisions that had been made and how, if identifiable, those decisions had been
reached. More recently, theories of business finance have emerged and been tested so that the
subject now has a firmly based theoretical framework – a framework that stands up pretty well to
testing with real-life events. In other words, the accepted theories that attempt to explain and
predict actual outcomes in business finance broadly succeed in their aim.

Business finance draws from many disciplines. Financing and investment decision making relates
closely to certain aspects of economics, accounting, law, quantitative methods and the behavioural
sciences. Despite the fact that business finance draws what it finds most useful from other
disciplines, it is nonetheless a subject in its own right. Business finance is vital to the business.

Decisions on financing and investment go right to the heart of the business and its success or
failure. This is because:

• such decisions often involve financial amounts that are very significant to the business
concerned; and
• once made, such decisions are not easy to reverse, so the business is typically committed
in the long term to a particular type of finance or to a particular investment.

Although modern business finance practice relies heavily on sound theory, we must be very clear
that business finance is an intensely practical subject, which is concerned with real-world decision
making.

1.2. THE MEANING OF BUSINESS FINANCE

Business finance refers to the management of money and other assets in an organisation. 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.

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Essentially, business finance is the backbone of any successful enterprise, providing the necessary
foundation for growth and sustainability.

The scope of business finance encompasses everything, ranging from financial planning, risk
assessment, and investment decision-making to financial statement analysis, capital structure, and
working capital management. Basically, it is the backbone of an organisation that supports all
operations, from procurement to marketing and human resources.

In every company, the importance business finance is rooted in three key areas: (i). Strategic
decision-making, (ii). Resource allocation and (iii). Risk management

i. 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.
ii. 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. Proper budgeting and financial planning contribute to the
sustainability and growth of the business.
iii. Risk Management: Managing financial resources is essential for mitigating risks and
uncertainties in the business environment. Business finance helps in identifying and
analysing 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.

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1.2.1. Key Functions of Business Finance

For any small or large business, business finance is one of the important functions. In fact, it is
one of the central departments that maintains relationships with all other departments within the
organisation. Below are the core functions of business finance?

1. Raising capital: Raising capital is the most important function of business finance. Taking
decisions on raising capital is one of the key functions of the business finance department.
It is the finance team that decides how to raise capital. There are various options available
in the market to raise funds such as equity financing, business loan, financial aid through
MSME schemes, and so on.
2. Working capital management: Managing working capital is one of the challenges faced
by MSMEs. Business finance draws a strategy to ensure that the company’s day-to- day
operations are carried out without any financial hic-ups. Therefore, it is one of the
important functions of the business finance department. It involves monitoring and
controlling the company’s cash flow, accounts receivable, and inventory and liabilities like
accounts payable. The finance department ensures smooth day-to-day operations. The goal
is to maintain an optimal balance between these components to meet operational needs
without tying up excess capital.
3. Investing capital: Another important objective of business finance management is
investing capital. The finance team evaluates various investment opportunities and decides
where to allocate funds. While undertaking this task, the team also assesses the potential
risks and returns associated with each investment option.
4. Safeguarding investment: In today’s uncertain market conditions, investing capital is not
enough. One has to keep monitoring the investment for maximising profits and lowering
risks. Business finance management mitigates such risks by safeguarding investments.
5. Risk mitigation: Another important function of business finance management is to
mitigate risk. In today’s era, markets are volatile and hence, risk mitigation plays a crucial
role. Business finance management ensures the strong financial health of the company. To
enable this, it is important to invest wisely, take calculated risks and constantly monitor the
market.
If the financial health of the organisation is maintained, companies need to find alternate
ways to raise funds such as refinancing the business, loan restructuring, and so on.
6. Financial planning: Financing planning includes confirming the vision and objectives of
the business and drawing a financial plan to achieve these objectives. To achieve this, the

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 business finance function sets budgets, identifies risks involved with created budgets, etc.
Moreover, the business finance function takes care of financial planning to ensure the
company adapts to changing financial needs. It also involves securing and managing the
current assets of the company.
7. Other functions: Depending on the size of your business, other functions of business
finance management include taking decisions about liquidity, mergers and acquisitions,
dividends, etc.

1.2.2. The Relationship Between Business Finance and other Business Functions

The role of business finance is not just limited to investment and raising capital. In fact, without
finance, other departments may not be able to function. Here is how the finance management
function closely works with other business functions in the organisation.

The Relationship Between Business Finance and Accounting

Business finance and accounting are not the same thing. Accounting is concerned with financial
record keeping, the production of periodic reports, statements and analyses. It is also concerned
with the dissemination of information to managers and, to some extent, to investors and the world
outside the business. It is also much involved with the quality, relevance and timeliness of its
information output. Obviously, financial decision makers will rely heavily on accounting reports
and the accounting database generally. Knowledge of past events may well be a good pointer to
the future, so reliable information on the past is invaluable. However, the role of the financial
manager is not to provide financial information but to make decisions involving finance.

In smaller businesses, with narrow portfolios of management skills, the accountant and the
financial manager may well be the same person. In a large business, the roles are likely to be
discharged by different people or groups of people. Not surprisingly, many financial managers are
accountants by training and background, but many are not. With the increasing importance of
business finance in the curricula of business schools and in higher education generally, the
tendency is probably towards more specialist financial managers, with their own career structure.

Business Finance Vs Production/Manufacturing

• Providing funds for purchasing raw materials, new machinery, maintenance of existing
machinery, etc.

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 • Evaluating the cost-effectiveness of current production processes and maximising
productivity

Marketing

• Allocating funds for various marketing activities such as advertising, promotions, etc.
• Evaluating the business impact of the marketing campaign

Sales

• Analysing revenue streams, pricing strategy, sales performance and profitability

• Generating bills for customers and ensuring timely payments

Human Resources

• Handling payroll and compensation packages for employees

• Allocating resources for recruitment, training and reskilling programmes for employees

1.2.3. The Objectives of Business Finance

The principal objectives of finance are to raise capital to earn adequate profit through investment,
conservation, and efficient utilization of investable capital.

a. Raising of Capital: Finance’s first and foremost objective is to raise the capital needed for
the organization concerned. The financial manager attempts to raise the capital
economically so that excess funds do not remain idle or a shortage of funds does not create
a bottleneck in running the business.
b. Investment of Capital: The second objective is to invest the capital raised appropriately
and in proper sequence. By investment of funds, we mean financial managers should decide
where corporate money may be invested. Generally, money should be invested where it
will do the most good. In a corporate setting, this means being profitable.
c. Protection of Capital: It is also the objective of finance to protect the capital invested in
the business. Uncertainty always prevails in the business world. If the investment is made
unwisely and un-prudently, it may bring disaster to the business unit. Therefore, to fulfil
the objective of finance, the risk of loss and protection of capital must be given due
consideration.

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 d. Minimization of Cost: One objective of finance is to minimize the cost of funds to
maximize shareholders‘ wealth. That involves examining all alternative sources of
financing. A firm may decide to issue bonds instead of stock. Bonds are riskier than stocks;
on the other hand, bonds cost less than stocks. Here, the firm accepts the risk of borrowing
in exchange for a lower cost of funds.
e. Maximization of Profit: One of the important objectives of finance is to maximize the
firm‘s profit. The financial manager would take actions expected to make a major
contribution to the firm‘s overall profits. For each alternative being considered, the
financial manager would select the one expected to result in the highest monetary return.
f. Maximization of Wealth: The other most important objective of the firm is to maximize
the wealth of the owners for whom it is being operated. The wealth of corporate owners is
measured by the share price of the stock, which in turn is based on the timing of returns,
magnitude, and risk.
g. Maintain Firm Value: One of the important objectives of finance is to maintain the firm‘s
value. It is generally believed that the firm‘s value is maximized when the cost of capital
is minimized. The optimum capital structure exists the value of the firm is maintained
constantly. So, maintain firm value associated with the formation of optimum capital
structure.

1.2.4. The Organisation of Businesses

This course is primarily focused on business finance as it affects businesses in the private sector
in Uganda. Most of our discussion will centre on private businesses. Irrespective of whether we
are considering large or small businesses, virtually all of them will be limited companies.

Since the limited companies are predominant in private sector, we shall discuss business finance
in this context. The principles of business finance that will apply equally, however, irrespective of
the precise legal status of the business concerned.

The private sectors of virtually all of the countries in the world are dominated by businesses that
are very similar in nature to Ugandan limited companies. We shall now briefly consider the legal
and administrative environment in which limited companies operate. The objective here is by no
means to provide a detailed examination of the limited company; it is simply to outline its more
significant features. More particularly, the aim is to explain in broad terms those aspects that

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impinge on business finance. Having a broad understanding of these aspects should make life
easier for us in later discussions.

What is a Limited Company?

A limited company is an artificially created legal person. It is an entity that is legally separate from
all other persons, including those who own and manage it. It is quite possible for a limited company
to take legal action, say for breach of contract, against any other legal persons, including those
who own and manage it. Actions between limited companies and their owners or managers do
occur from time to time.
Obviously, an artificial person can only function through the intervention of human beings. Those
who ultimately control the company are the owners who each hold one or more shares in the
ownership (or equity) of it.

What is Limited liability?

One of the results of the peculiar position of the company having its own separate legal identity is
that the financial liability of the owners (shareholders) is limited to the amount that they have paid
(or have pledged to pay) for their shares. If the company becomes insolvent (financial obligations
exceed the value of assets), its liability is, like that of any human legal person, limited only by the
amount of its assets. It can be forced to pay over all of its assets to try to meet its liabilities, but no
more. Since the company and the owners are legally separate, owners cannot be compelled to
introduce further finance.

The position of a shareholder with regard to limited liability does not depend upon whether the
shares were acquired by taking up an issue from the company or as a result of buying them from
an existing shareholder.

1.2.4. Long-term Financing of Businesses

Much of the semi-permanent finance of companies – in a small minority of cases, all of it – is

provided by shareholders. Many companies have different classes of shares. Most companies also
borrow money on a long-term basis. (Many borrow finance on a short-term basis as well.) In later
chapters we shall examine how and why companies issue more than one class of share and borrow
money; here we confine ourselves to a brief overview of long-term corporate finance.

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1. Ordinary shares: Ordinary shares are issued by the company to investors who are
prepared to expose themselves to risk. They do this so that they also expose themselves to
the expectation of high investment returns, which both intuition and the evidence.
Ordinary shares are frequently referred to as equities. It is normal for companies to pay
part of their realised profits, after tax, to the shareholders in the form of a cash dividend.
The amount that each shareholder receives is linked directly to the number of shares owned.
The amount of each year’s dividend is at the discretion of the directors.

Dividends are often portrayed as being the reward of the shareholders, in much the same
way as a payment of interest is the reward of the lender. This is, however, a dubious
interpretation of the nature of dividends. All profits, whether paid as dividends or
reinvested in the business, belong to the shareholders. If funds generated from past profits
are reinvested, they should have the effect of causing an increase in the value of the shares.
This increase should be capable of being realised by shareholders who choose to sell their
shares. It remains the subject of vigorous debate whether reinvesting profits is as beneficial
to the shareholders as paying them a dividend from the funds concerned.

2. Preference shares: Preference shares represent part of the risk-bearing ownership of the
company, although they usually confer on their holders a right to receive the first slice of
any dividend that is paid. There is an annual upper limit on the preference share dividend
per share, which is usually defined as a percentage of the nominal value of the share.
Preference share dividends are usually paid in full. Preference shares give more sure returns
than equities, though they by no means provide certain returns. Preference shares do not
usually confer voting rights.

Preference shares of companies are traded in the Stock Exchange. As with equities, prices
of preference shares will vary with investors’ perceptions of future prospects. Generally,
preference share prices are less volatile than those of equities, as dividends tend to be fairly
stable and usually have an upper limit. For most companies, preference shares do not
represent a major source of finance.

The relationship between the fixed return elements (preference shares and loan notes), on
the one hand, and the equity, on the other, is usually referred to as financial gearing or
capital gearing (‘leverage’ in the USA).

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Raising and Repaying Long-Term Finance

Broadly speaking, companies have a fair amount of power to issue and redeem ordinary shares,
preference shares and loan notes, also to raise and repay other borrowing. Where redemption of
shares (both ordinary and preference) is to be undertaken, the directors have a duty to take certain
steps to safeguard the position of creditors (that is, those owed money by the business), which
might be threatened by significant amounts of assets being transferred to shareholders.

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