What is Finance? Definition & Types of Finance

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What is Finance? Definition and Types of Finance

Hub Accounting What is Finance? Definition and Types of Finance

You can’t run your business effectively without knowing how finance works and having a plan for how you’ll spend the money you earn. Understanding money management helps small businesses coordinate financing activities, avoid bankruptcy, limit risks, and get the best possible returns on different investments.

Finance is a broad subject, and it can get overwhelming along the way. To help you grasp the basics, we’ve covered essential information you need to know about how finance works for small businesses.

Here’s What We’ll Cover:

What Is Finance?

The 3 Types of Finance

What Is the Difference Between Finance And Accounting?

Why Is Finance Important for a Small Business?

Key Takeaways: Finance

More Finance Resources for Businesses

What Is Finance?

Finance is simply how an individual or an organization manages its financial resources. It can include borrowing, investing, lending, budgeting, saving, spending, and forecasting.

While people tend to think of finance in terms of money, finance is about more than cash. While money is a legal tender used for many financial transactions, finance refers to asset allocation and management of monetary resources.

Finance cuts across multiple activities and departments, including developing a cash flow forecast for your business, keeping money in a high-interest savings account, and creating budgets and financial models.

The 3 Types of Finance

Finance is broadly categorized into 3 categories: personal finance, public finance, and corporate (or business) finance.

1. Personal Finance

Personal finance refers to managing an individual’s monetary resources across 5 key areas: Income, savings, investments, spending decisions, and asset protection. The goal is to make intelligent investment decisions and build a safety net and meet their goals without taking on too many debt obligations.

A personal financial system can also involve generational wealth transfer, taking advantage of tax planning opportunities, filing tax returns, using credit cards, and buying, selling, and managing assets. Personal finance is always tailored to one’s specific needs in the short, medium, or long term.

This means that two people may not make the same financial decisions because of their different goals, earning potential, incomes, and timeframes. For example, paying off a loan can be your short-term goal, while investing in real estate or the stock market might be a long-term priority.

How Personal Finance Can Impact Your Business

Business owners must develop a strategic personal finance plan to protect them from unforeseen circumstances. For example, having personal savings may help you raise startup capital for your business, and saving for retirement helps the business owner avoid running out of money and being forced to sell the business.

2. Public Finance

Like individuals, governments must allocate their resources to different sectors of the economy. Public finance is how federal, state, and local institutions track revenue and manage expenses for all the services they provide to the public.

Some of a government’s most essential functions include collecting money from the public sector via taxes, raising capital through bonds, and channeling money into a broad range of services that benefit the public. When the public sector distributes tax revenues across multiple functions, including debt servicing, infrastructural development, and recurring expenditures. By overseeing income generation and government spending, government agencies help ensure a stable economy and prevent market failure.

Other aspects of public finance include tax management, debt issuance, budgeting, international trade, and inflation regulation. These factors have a direct and lasting effect on business and personal finance.

3. Business Finance (Corporate Finance)

Business finance, or corporate finance, covers all the financial activities related to running a business. You can think of this in terms of acquisitions and investments, funding, capital budgeting, risk management, and tax management needed for business growth in financial markets.

Companies must balance cash flow, risks, and investment opportunities to increase their value and strengthen their capital structure.

A great example of corporate finance is when a business chooses between equity financing and debt financing to raise capital. Equity financing is the act of securing funding through stock exchanges and issues, while debt finance is a loan that must be repaid with interest on an agreed date.

Businesses have to develop a revenue-generation plan which determines business profitability in the medium- and long term.

What Is the Difference Between Finance and Accounting?

Accounting and finance are both important to the success of any small business; however, they are not the same. The key difference between finance and accounting comes down to how they consider a company’s financial records.

Accounting focuses on cash inflow and outflow, reconciling a company’s financial statements and records, and delivering financial information to lenders, investors, and the general public.

Finance, on the other hand, uses accounting reports and documents to develop strategies that improve growth and profitability for businesses. Finance activities might include asset management, selecting the right financial instruments to invest in, financial modeling, and portfolio optimization.

Why Is Finance Important for a Small Business?

Small business owners don’t have to become financial managers or hire a chief financial officer to benefit from business finance. In fact, you may already be using financing information from your balance sheet, income statement, and cash flow statement to run a profitable business.

Here are several reasons finance is important to your small business:

It drives strategic financial decision-making, such as buying insurance or deciding which financial products or financial institutions will allow you to earn interest.

It helps you decide where to allocate resources and how to manage cash flow.

It allows you to define long-term goals that will allow you to grow and scale.

It helps you to understand the time value of money.

Key Takeaways: Finance

Finance is an all-encompassing term that covers resource and money management for individuals, public institutions, and businesses. There are 3 types of finance: personal finance, public finance, and business finance.

Running any business without understanding how money works puts many things on the line. Besides putting your company at risk of bankruptcy, poor money management results in unpredictability, which is bad for every business. The good thing is you don’t need a bachelor’s degree in finance to understand the basics highlighted in this article and apply them to your business.

More Finance Resources for Businesses

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6 different types of finance to help your business grow

Cash flow lending

Cash flow loans are usually short-term loans to help you maximise a business opportunity or manage a lumpy cash flow.

Features can include faster applications and less paperwork, cash-flow friendly repayments and transparency around the total amount to be repaid.

Keep in mind that not all lenders’ products are created equal: some don’t offer a fixed upfront price, leaving owners susceptible to interest rate rises, while others may include hidden fees and charges.

Invoice finance

Invoice finance can help small businesses like tradies maintain cash flow when waiting for customers to pay. There are two types of invoice financing:

Invoice factoring: Where you sell your invoices to a third party at a reduced cost in exchange for instant payment.

Invoice finance: Where you use an invoice you have issued as security to get a loan.

Some invoice finance providers offer 100% of the invoice value in exchange for a drawdown fee and an ongoing weekly interest rate. Invoice financing may be useful if you often have to wait for payment after completing projects and purchasing materials. To use invoice finance you need to be the kind of business that issues invoices – like a professional services firm or a tradie, rather than a cash-based business like a cafe.

Crowdfunding

Popular in the social and charitable space, crowdfunding has recently matured in the business arena, with platforms like Snowball Effect facilitating substantial amounts of private investment in New Zealand.

The most common crowdfunding model is based on rewards and incentives. A ‘backer’ pledges money to support your business or product idea in exchange for a discount on the new product or another reward. Rewards could range from a percentage of revenue to free products or the opportunity to help in the design process.

On the upside, business owners keep full ownership and clients are investors – providing direct access to market feedback. For investors, there may be low risk for small amounts.

On the downside, some platforms might not provide access to funds if the overall goal isn’t reached. Business owners may need to commit time to promoting the campaign and dealing with backers, and still need to deliver on their promises if things don’t go to plan.

Crowdfunding may suit a businesses just starting out rather than an established business. It may not be a viable solution if you need help managing cash flow.

Need access to cash, quickly? See how a Prospa Small Business Loan could help you get much needed funds for your business.

Angel investors

Angel investors are often business owners or high net worth individuals who see the potential in your business and want some involvement. They usually invest in industry sectors they’re familiar with and will want a targeted return on their investment. They may structure their involvement as a loan, or as equity, or a combination of both.

Angel investors often come on board in the early stages of a business and contribute their experience and knowledge in addition to funding. It can be important to consider choosing an investor who can add value and has the same vision for your business that you do.

Venture capitalists

Venture capitalists (VCs) are investment companies or fund managers who usually provide cash in return for part-ownership of your business. They tend to look at larger businesses and differ from angel investors in that they typically want to invest larger amounts and have more comprehensive requirements.

VCs may not want to play an active role in the management of your business, instead taking a seat on your board. To find out more about venture capital opportunities in NZ, check out the NZVCA.

Small business loans

Prospa small business loans offer flexible repayment options that work with business cash flow. Decisions are fast and funding is possible in 24 hours.

There’s no asset security required upfront to access Prospa funding up to $150K and, at the time of publication, borrowers can choose to delay repayments for the first four weeks (loan term will be extended and interest will accrue from settlement until the end of term).

What type of finance is best for your business?

Here are some key things to consider when deciding if debt or equity finance best suits you.

How much do you need to borrow?

The first thing you need to know is how much money you’ll need. You can get an idea of this through a number of different methods:

If you’re starting a business – add up your set-up costs such as rent, equipment, shop fit-out, inventory, wages and super contributions (including your own), legal and accounting costs.

If you’re purchasing an asset – ask for a copy of the contract with the purchase price.

If you’re borrowing for cash flow purposes – use cash flow forecasts to identify any shortfalls. The CommmBank financial plan template includes a cash flow template you can use to do this.

By comparing this amount to the cash you have available, you can gauge how much money you may need to borrow. To reduce financial stress, if it looks like you need to borrow a larger amount, you may want to consider ideas that can save you more money or, if you can, keep working your existing job for extra income.

Another option can be to apply for federal government grants for some new businesses.

Debt finance

Debt finance is borrowed money that you pay back with interest within an agreed time. The most common types include:

Bank loans

Overdrafts

Mortgages

Credit cards

Equipment leasing and hire purchase.

Advantages of debt finance

You have control over your business and assets as you don't need to answer to investors

You don't have to share your business profit

Some interest fees and charges on a business loan may be tax deductible – your accountant can advise you on this.

Considerations for debt finance

New businesses may find it difficult to secure debt finance without accurate financial records or projections and a comprehensive business plan

You’ll need to generate enough cash to service repayments, fees and interest

Regular repayments can affect your cash flow. Start-up businesses often experience cash-flow shortages that may make regular payments difficult

If you use an item as security to guarantee a loan, the item could be repossessed should you be unable to make repayments.

Equity finance

Equity finance is investing either your own or someone else's money in your business. The key difference between debt finance and equity finance is that the investor becomes a part owner of your business and shares any profit the business makes.

The main sources of equity capital are:

Family and friends

Business angels – individuals who invest their own funds (typically up to $2 million) into start-up businesses

Crowd funding – this relies on people to donate money to a business

Venture capitalists – professional investors who invest funds (generally $2-10 million) in operating companies

Public float – raising money by issuing securities (e.g. shares) to the public.

Advantages of equity finance

Freedom from debt and no repayments

Considerations for equity finance

Shared ownership means you may have to give up some control of your business. Investors not only share profits, they may also have a say in how the business is run

Accepting investment funds from family or friends can affect personal relationships

You may have to compete with a number of other business for funding from the same source, making it harder to get the cash you need.

What next?

See which type of debt finance may suit your business or set up a meeting with a CBA Business Banker to discuss your finance options.