Business Financing

What It Means

Business financing is just it what it sounds like: the activity of funding the many aspects of a business, whether the funding be for starting a business, running it, or expanding it. Regardless of the size or type of business, there are fundamental questions involving financing that must be addressed.

For example, most businesses purchase a variety of items, such as buildings, machinery, or office furniture and equipment, that are intended to be useful for a long time. Such items are called long-term investments. Any business making long-term investments must carefully consider what those investments will be, how much they will cost, and how much they will hold their value over time. Just as important is the question of where to get the money needed to pay for them.

When a business is just starting, it typically borrows money from banks or other financial institutions, or it brings in additional individuals or institutions (that is, investors) to share ownership in the business in order to procure the initial capital it needs to cover the costs of building a new business. Capital is the term given to the money or other things of worth that are needed to produce goods or services. Capital can take the form of human beings, physical goods, or some means of financial exchange. Examples of capital are skilled labor, factories, office space, tools, machinery, and money.

When a businesses is up and running and managing the everyday financial operations, it may likewise turn to banks and investors for financing, but it typically relies on its customers for generating the money needed to finance the business. If the business is profitable and the company saves some of the money it makes from commercial activity, it may use that money to make new investments that will further expand its business. There are many different methods businesses use to acquire the financing they need to fund large projects and to improve their profitability.

When Did It Begin

Recorded instances of business financing date back to ancient times when wealthy Greeks arranged loans to shipping concerns that needed financing to transport freight. Greek lenders also funded miners and erectors of public buildings. In the Middle Ages Jewish merchants living in Italy loaned money to Christian Italian farmers. This practice established merchants in Europe as the main source of loans for farms and businesses and originated the concept of the “merchant bank.”

In 1781 the first commercial bank was established in the United States. Named the Bank of North America, it extended short-term loans to merchants who then passed them on to wholesalers of imported goods. The wholesalers, in turn, extended loans to retailers, often country stores and independent peddlers.

Another step in the development of business financing in the United States was taken in 1904, when the American banker A.P. Giannini (1870–1949; later to be nicknamed “America’s banker,”) opened the Bank of Italy in San Francisco in 1904. Immigrants who sought to borrow money to start businesses but had been turned down because they had no established wealth were supported by the Bank of Italy, which became the Bank of America in 1930. California industry and agriculture and Hollywood filmmaking were among the many interests supported by Giannini’s financing enterprise.

The Small Business Investment Act of 1958 established ways to make venture capital (funds from investors seeking to share ownership in new businesses) and long-term loans available to small, independent businesses in the United States. This program was the first to give small American businesses the financing they needed to start, maintain, and expand their operations.

More Detailed Information

As businesses grow, their financing needs evolve and typically become more complex. In the case of a small business, the owner generally makes the financial decisions for the firm. In the case of a large company, the owner or owners (who in some cases are the stockholders) do not get involved in financial decisions. Instead, they hire managers who take on the financial responsibilities. In large companies, this person is known as the chief financial officer (CFO) or vice-president of finance.

The process of planning and managing the long-term investments of a business is known as capital budgeting. Usually this process involves seeking those business opportunities that will earn the company more than they will cost the company. For each type of business, these opportunities are distinct. For example, for a commercial airline the decision about whether to begin regular service to a new city would be an important capital budgeting decision. For a large discount retailer the decision about whether to introduce a new line of gardening products would be one. Other types of capital budgeting opportunities (for example, investments in computer systems or human labor) are common to almost all businesses.

When a company’s financial manager reviews a proposed capital budgeting decision, he or she must respond to several issues concerning the flow of cash associated with an investment. Primary considerations are the amount of cash the company is likely to make from an investment, when the company can collect the cash, and how high is the risk of the investment (that is, the chance of losing money in it). Basically, all capital investments must be evaluated for their size, timing, and risk. In the example of the airline’s beginning a new route, mentioned above, the financial manager must estimate how much money the company will make once the route is established, when it will earn the money, and how reliable the new market will be.

When a company makes a long-term investment, as it does when it decides to develop a new product or open a new division, it must know from where the needed money will come: from outside the company, from within the company, or some combination of the two. Long-term investments require what is called long-term financing. The financial structure (sometimes called the capital structure) of a company is the particular mix of long-term borrowing and the equity that it can use to pay for its operations and new investments. The company, for example, may have a certain amount of long-term debt incurred from borrowing money for its startup or to make new investments. The equity is the market value of the business’s property held by the owners and shareholders. Financial managers constantly weigh the levels of debt and equity. Equity allows a company to keep growing and gives it its value. Debts must be kept under control because they represent the level of financial risk a company takes upon itself; the greater its debts, the greater it risks financial instability.

The term “working capital” refers to the short-term investments a business can draw upon. A business’s short-term investments may be the inventory of goods it has produced. A business also may have short-term debts in the form of money it owes to the suppliers who provide materials to the business. The owners or the financial manager of the business must manage these short-term investments and debts of the firm on a daily basis so that the firm does not lose track of its costs, run out of ready cash, or interrupt its operations.

Recent Trends

An area of business finance that has grown steadily in the late twentieth and early twenty-first centuries is the practice of extending small loans to poor entrepreneurs who live in developing countries. The practice is known as microlending, and the loan is often called microcredit. The purpose of microlending is to assist individuals in creating income for themselves (for instance, by farming, weaving, or making crafts) and therefore to improve their living standards. Usually the individuals borrowing money have no existing property to use as collateral and no credit history and so would not qualify for a traditional bank loan.

Microcredit is generally issued for a short time period (one year or less), and the terms mandate that it be paid back on a weekly basis. Interest rates on the loans generally are high (in some places 40-50 percent) because costs of running the programs are high. The loan programs also generally seek to improve the education and health care of those enrolled. Microcredit is extended to women more often than men, and usually it is arranged as a community program, which cultivates responsibility to repay the loans because the whole community takes on the risk involved in improving the financial situation of its constituents.