Finance is a field that studies topics such as borrowing money to receive a greater return on the funds. Finance is important in business because debt payments often require paying a lower rate of return than investors expect with other instruments such as common and preferred stock. Finance allows a company to receive the money necessary to pay bills such as workers’ wages, rent and utilities without giving up ownership rights through the sale of stocks.
Finance includes the study of return expectations. When a company decides to borrow money, it includes risk in the calculations of the return it will receive. A company that borrows a million dollars may predict that it has a 50 percent chance of earning two million dollars with its investment and a 50 percent chance of earning five hundred dollars. The company averages the two numbers and expects that it will receive a return of a million and a half dollars.
Risk Averse Investors
Risk includes the study of variance. If a company can receive a million dollars half the time, and the other half of the time receive nothing, or it can receive a guarantee that it will receive five hundred thousand dollars, its financial analysts will usually recommend that it pursue the option with a guarantee to receive five thousand dollars. According to New York University, most investors are risk averse, so they will require additional returns before they accept a decision that includes larger amounts of potential risk.
The Necessity of Finance
Finance is necessary for many small businesses. Stock exchanges often require a minimum share value and company size before a company’s shares may trade on the exchange. Since the small business owner can not sell shares of a company to the public, the owner must borrow money from banks and other sources to finance the expenditures of the small business.
Finance includes the study of cash flow. A company must pay its bills as they become due. This may include temporarily borrowing money at a higher return than the company is earning on its sales if it is necessary for the company to continue operating. Financial professionals make sure that the company’s incoming revenues match its bill payments, by matching current assets such as cash with current liabilities such as the amount of bond interest due during the current year.
Cost of Capital
The cost of capital is an important area of finance. Businesses can often borrow funds from several sources, such as credit cards at high interest rates and bank loans at lower rates. Financial calculations provide the rate of return from investing additional funds into company operations, determining whether it is worthwhile to borrow money from sources with a specific interest rate.