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The business sector as we know it today is the hub of a capitalistic society and a natural descendant of a barter society. When money became the medium of exchange, domestic and international trade grew quickly because parties no longer had to search for a counterparty with the opposite needs at the same time, and entrepreneurs now had the financial instruments to raise large amounts of money on various terms.
These are some of the key financial concepts that business managers need to understand to ensure a high chance of their business’s survival and success. The concepts will be discussed in a forthcoming course from the European Centre of Technology (ECT) called: Finance for Non-Financial Managers. For more details of the course, please contact [email protected]
Modern businesses need money to operate and through their stewardship they aim to generate additional money. Money is therefore the input and the output and success is usually measured in terms of how much additional money has been generated.
Since the amount of additional money is the measure of success, managers at all levels and departments of a business need to understand the variety of sources globally that money can be obtained from, how to protect it and use it efficiently, and how to extract it.
In modern society, since money is so important, a sector – the financial services sector – has developed and been nurtured over centuries so it now contributes a significant (in some countries such as the UK, the most) of a country’s entire annual output (GDP). Whether individuals realise it or don’t, its activities pervades their existence, whether they are the chancellor of the exchequer managing a multi-trillion economy, or a sole-trader setting up his business with a small bank loan.
The financial services sector guides businesses through the often complex, lengthy and very expensive process of obtaining money. It helps businesses manage the risks associated with that money, such as avoiding problems that often arise when interest or exchange rates rise or fall, or against default by counterparties.
Many people will have experienced these problems if they have a mortgage, or when they go on holiday overseas, or when they lend a friend money.
The analogy at the personal level is appropriate because to understand a business it often helps to think of it as a person not just a legal fiction, and for the business manager or business owner to think of themselves as individuals dealing with another person (their business). Just like a person, a business has rights and obligations, for example to sue an individual or another business for breach of contract, or the obligation to pay interest. If the business does not honour its obligations then its possessions can be seized and sold to repay its creditors and it can be declared insolvent. Similarly, an individual’s possessions can be seized and sold to repay their creditors and they can be declared bankrupt.
Just as an individual needs to be fed regularly, so a business needs to be fed daily with money to continue to operate. This intake of money is often called working capital and is used to buy things the business needs to work, such as: raw materials to make its products, to pay salaries to people who operate the business, to pay bills for energy used to run machines, to pay rent for the buildings that house those machines, to buy petrol for the cars that deliver the products to the retailers, to pay the government and local authorities various taxes, and to pay the bank interest for the loan it gave.
The job of the business manager is to keep the business from insolvency and better still, to keep it fit and healthy (just as an individual wants to keep their possessions and stay healthy).
The business might allow buyers of its products thirty days to pay, so it sends them an invoice. This means it won’t get paid for thirty days, but what if the buyer defaults so the business does not get the money it was owed? How will the company continue to operate? The business is not a charity so its employees will not work for nothing and its creditors will soon be knocking on the door demanding money. The bank manager will soon threaten to send a receiver to sell the business’s valuable items to get its loan money back – meaning the business cannot operate and is effectively out of business.
Budgeting and forecasting are key to success in business. These factors perhaps should not come as a surprise by now since we have seen there are many similarities between a business and an individual, and we know that planning and forecasting are important money management disciplines for an individual:
You probably know that spending more than you can afford will soon land you in trouble with you energy suppliers if you cannot pay their bills. If you had looked ahead, you would have realised you have (for example) this quarter’s rent to pay and pay day is too far away and you’re already overdrawn at the bank.
Had you kept up to date records of money coming in and where it is being spent, you would have realised long ago that you’re expenses are more than your income and you are therefore heading for trouble. Whilst an individual can be relaxed about keeping records, businesses have a legal obligation to keep them and to prepare them to a high standard and provide them on time to various interested parties (such as the taxman, business owners and to lenders). Key financial statements a business must prepare are its balance sheet, profit and loss account, and its cashflow statement. Each has a very important purpose.
The balance sheet is a snapshot showing what the business owns and what it owes. It owns, for example, its raw materials, factories, machinery and the money owed by buyers who have not yet paid. It owes loans, interest, trade suppliers, salaries and taxes. As long as the net amount of what it owns (assets) and what it owes (liabilities) is positive, the business will stay out of insolvency. The surplus is the amount owed to the owners of the business (equity). Assets, liabilities, and equity amounts change daily and require the skill and attention of all managers to keep them in the right proportion.
The profit and loss account summarises the income and expense of the business over a year of trading, and again, this should show more income than expenses. The cashflow statement summarises where the money came from and where it was spent in that year of trading.
Often a business will have several projects available that each require money and have different projected outcomes. A business usually cannot undertake all of them so it needs to select the optimum one or ones to pursue. Investment appraisal with limited resources is therefore another management skill that has a direct bearing on business success.
This article has introduced some of the key financial concepts that business managers need to understand to ensure a high chance of their business’s survival and success. The concepts will be discussed in a forthcoming course from the ECT called: Finance for Non-Financial managers. For more details of the course, please contact [email protected]
Dr Permjit Singh (www.permjitsingh.com) is a corporate finance consultant and former corporate treasurer, who also lectures on international finance and bank financial management.
The Finance for Non-Financial Managers course will explain and demonstrate concepts that individuals at all levels of the business need to understand, in order to ensure their organisation’s survival and long-term success.
To find out more about the 2-Day Finance for Non-Financial Managers course, which takes place regularly at the University of London, please visit:
https://theECT.org/finance-for-non-financial-managers or email [email protected]