Business finance - Basics |
Anyone who runs a business will tell you that you can not start a business with nothing. Every business is started with money or something with a monetary equivalent. Suppose you decide to start a business to produce and sell fresh vegetables. To do this, you either hire people to help you or you can choose to do everything yourself. To start off you are going to clear the field for planting your vegetables, buy irrigating or watering equipment, buy or make storage facilities for your harvested vegetables. At the end of the day you are going to end up with all the tools you bought or made and the inventory (your harvested vegetables). Notice here that before you could produce vegetables for selling, you had invested in assets such as the equipment, inventory (your vegetables), the land and labor. Thus when you sell your vegetables you should expect to generate the cash that should be worth at least the value of what you invested in the production and selling process. This in business terms is called "value creation". Where does your investment come from?If you had enough money in your personal savings, retirement, etc; to start your business your total investment will be from you. This in finance terms is called "Owner's equity". If you did not have enough money to start the business, you would have considered borrowing from family members, banks, credit unions or other institution. How the business is financed , in other words; how the business' value is sliced up is called "the business' Capital structure". This reflects the percentage value that comes from creditors or Debt, the percentage raised by owners or Owners' Equity. This means the total value of the business is represented by the sum of the market value of its Debt and the market value of its Owners' equity: In Mathematical terms this could be represented as: V = D + OEWhere V is the total value of the business, D is Debt and OE denotes owners' equity. Note that the business' capital structure affects its value. Say for example, if you borrowed 80% of your capital then you have got to understand that your costs of running the business is high. Thus, your primary responsibility is to buy or invest in Assets that generate more revenue than they cost in order to offset the cost of your Debt. In other words you have to create more cash flow into the business than it uses. To be able to run a profitable business, the timing and of your cash flow is just as important as anything else in the business. The more and earlier money coming into the business, the better. The same goes for money that flows out of your business. The less and later money that flows out of the business without getting penalized, the better. Why? If you have more money coming into the business earlier in the month and you only repay fewer debt later in the month, you have more money to work with and for a little longer (the money with which you can add value to your business). The reverse is a fatal scenario, where you have less money coming in over a period of time and have a large debt to pay early. In this case there is really no room to use the money to add value to your business. Remember your goal as a business is to:
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