Finance Management is the combination of two terms, Which are Finance and Management. Finance means money and funds, Management is a process through which these funds are managed.
When we talk about Business organization, one thing is for sure we cannot run this business if we do not have enough financial resources. So, How do we get financial resources? Financing activity is arranging finances. Arranging finances means that we need to get financing from some sources. We discuss Financing activity in detail.
The first thing that comes to our mind is that we'll have our own money that we have somehow generated from various sources. We call it equity. The equity of the people who are the owners of that business. Equity is any business's first or main source of financing. Once the equity is generated then the second source of financing is through debt. Debt means borrowing, taking a loan, and taking money and funds from people who are not the organization's owners. It means that we can get money from banks and other financial institutions.
When we look at sources, we say that we can classify these sources as external sources and internal sources. But mainly we know that when a business is to be initiated or when a business is to be started, there are no internal sources because it is a new business. In the beginning, we have got only external sources. When we classify financing, we classify them in external financing and internal financing. The external financing is the one which a business has to rely mainly.
Now, What is included in external financing and what do we mean by external financing that is external to what? There is a concept in accounting that is called the concept of a separate business entity. We need to know very well that every business organization is different from its owner. If I own a company, I am not the company myself. The company is a different entity and the business is a different entity. Anything which is not a company is external to the company. So, the money and funds from these people are external sources for the company.
We have got two major sources. The first sources are the funds that are provided by the owners of the business when it is a small business. Obviously, it is a person who is doing the business. When it is even a little bigger business then the partners who are the ones who are contributing to this business but when we talk about the corporation. So, here the equity providers are shareholders. The people who purchase small components of equity and other than equity we have debt that is a loan, that is the amount we are taking from some sources. Sources who are not the owner of owners of our business but are the lenders to the business.
The next thing we should learn is the time period of financing activity. The financing can be short-term or long-term. So, we should have long-term financing, short-term financing, and a mix of long and short-term financing. By the way, when we say that is long-term or short-term the line that differentiates the two is one year time period. It means that if financing is for one year or less than one year then it is called short-term financing and if it is for more than one year then it is called long-term financing. The needs of the business are different. Some of the needs are short-term and somehow the needs are long-term. So, accordingly, the finance manager has to see whether the requirement suits long-term financing or short-term financing. Short-term financing is generally cheaper means the cost of financing is lesser.
I have used the term cost of financing. The cost of financing means the return that we have to pay to the people who are providing us this financing. If a person who is giving us funds as equity funds that is shareholders or banks then the return we are giving to the person is called the profit that is distributed. The term we use for it is the dividend. If anyone provide us money as a lender then the return that we pay to that person or institution is what we called interest or markup and in some cases it is also called profit sharing. But if it is long-term financing then return is higher and in shorter financing this is lower in percentage. So, If an organization is having more long-term financing than the need then obviously we can understand that the firm or the company has to bear more cost which is obviously is not the desired objective of the organization.
The prim objective of the business is to make a profit, is to enhance its returns, or increase the wealth of the organization and this keeping this objective in mind for all these activities. So, the Cost of financing is the return that we have to pay to the fund's providers.
