CHAPTER 19
I. THE ROLE OF
FINANCE.
LEARNING GOAL 1.
Explain the role and importance of finance.
A. COMPARING THE
ACCOUNTANT AND THE FINANCIAL MANAGER.
1. The role of an
ACCOUNTANT is like a skilled technician who takes measures of a company's
health and writes a report.
2. FINANCIAL
MANAGERS use the data prepared by accountants and make recommendations to top
management regarding STRATEGIES FOR IMPROVING THE COMPANY'S FINANCIAL STRENGTH.
3. A manager cannot
make sound financial decisions without understanding accounting information.
4. The need for
careful financial management remains an ongoing challenge in a business
throughout its life.
5. The MOST COMMON
WAYS FOR FIRMS TO FAIL FINANCIALLY are:
a.
UNDERCAPITALIZATION, or not enough funds to start with.
b. POOR CASH FLOW,
or cash in minus cash out.
c. INADEQUATE
EXPENSE CONTROL.
B. THE IMPORTANCE
OF UNDERSTANDING FINANCE.
1. The text
describes a small organization called Parsley Patch, begun on a shoestring
budget.
2. When the owners
expanded into the health- food market, sales took off.
3. Neither woman
understood cash flow procedures or how to control expenses, and profits did not
materialize.
4. They eventually
hired a CPA and an experienced financial manager, and soon they earned a
comfortable margin on operations.
C. Financial
understanding is important to anyone who wants to invest in stocks and bonds or
plan a retirement fund.
II. WHAT IS
FINANCE?
LEARNING GOAL 2.
Describe the responsibilities of financial managers.
A. FINANCE is the
function in a business responsible for acquiring funds for the firm, managing
funds within the firm, and planning for the expenditure of funds on various
assets.
1. Without a
carefully calculated business plan, the firm has little chance for survival.
2. FINANCIAL
MANAGEMENT is the job of managing a firm's resources so it can meet its goals
and objectives.
a. Most
organizations will designate a manager in charge of financial operations.
b. Financial
management could also be put in the hands of the company treasurer or vice
president of finance.
3. The fundamental
task is to obtain money and then plan, use, and control that money effectively.
B. Both CREDIT and
COLLECTIONS are important responsibilities of financial managers.
1. Financial
managers are responsible for collecting overdue payments and minimizing bad
debts.
2. These functions
are particularly critical to small and medium-size businesses, which have
smaller cash or credit cushions.
C. TAX MANAGEMENT
is the analyzing of tax implications of various managerial decisions in an
attempt to minimize the taxes paid by the business.
1. As tax laws
change, finance specialists must carefully analyze the tax implications of
various decisions in an attempt to minimize taxes paid.
2. Businesses of
all sizes must concern them selves with managing taxes.
D. It is the
INTERNAL AUDITOR, usually a member of the firm's finance department, who checks
on the financial statements to make sure that all transactions are appropriate.
1. Without such
audits, accounting statements would be less reliable.
2. It is important
that internal auditors be objective and critical of any improprieties or
deficiencies.
III. FINANCIAL
PLANNING.
LEARNING GOAL 3.
Outline the steps in financial planning by explaining the process of
forecasting financial needs, developing budgets, and establishing financial
controls.
A. Financial
planning involves analyzing short-term and long-term money flows to and from
the firm.
1. The major
objective of financial planning is TO OPTIMIZE PROFITS AND MAKE THE BEST USE OF
MONEY.
2. The steps
involved in FINANCIAL PLANNING are:
a. FORECASTING both
long-term and short-term financial needs.
b. DEVELOPING
BUDGETS to meet those needs.
c. ESTABLISHING
FINANCIAL CONTROL to see how well the company is following the financial plans.
B. FORECASTING
FINANCIAL NEEDS.
1. A SHORT-TERM
FORECAST is a prediction of revenues, costs, and expenses for a period of one
year or less.
2. A CASH FLOW
FORECAST is a prediction of cash inflows and outflows in future periods,
usually months or quarters.
a. The inflows and
outflows of cash are based on expected sales revenues and on various costs and
expenses.
b. A firm often
uses its past financial statements as a basis for projecting expected sales and
various costs and expenses.
3. LONG-TERM
FORECAST is a prediction of revenues, costs, and expenses for a period longer
than 1 year, sometimes extending 5 or 10 years into the future.
a. This forecast
plays a crucial part in the company's long-term strategic plan.
b. The long-term
financial forecast gives top management some sense of the income or profit
potential possible with different strategic plans.
C. WORKING WITH THE
BUDGET PROCESS.
1. A BUDGET is a
financial plan that allocates resources based on projected revenues.
a. A budget becomes
the primary basis and guide for the firm's financial operations.
b. Most firms
compile yearly budgets from short-term and long-term financial forecasts.
2. There are
SEVERAL BUDGETS IN A COM PANY:
a. OPERATING BUDGET
(projection of dollar allocations to various costs and expenses needed to run
or operate the company, given projected revenue.)
b. CAPITAL BUDGET
(spending plan for assets whose returns are expected to occur over an extended
period of time-more than a year.)
c. CASH BUDGET
(projected cash balance at the end of given period.)
d. MASTER BUDGET
(financial plan that summaries the operating, capital, and cash budgets.)
3. Financial
planning often determines:
a. What long-term
investments are made.
b. When specific
funds will be needed.
c. How the funds
will be generated.
D. ESTABLISHING
FINANCIAL CONTROLS.
1. FINANCIAL
CONTROL means that the actual revenues, costs, and expenses are periodically
reviewed and compared with projections.
2. Most companies
hold at least monthly financial reviews as a way to ensure financial control.
3. Such controls
provide feedback to help re veal which accounts are varying from the financial
plans.
4. Some financial
adjustments to the plan may be made.
IV. THE NEED FOR
OPERATING FUNDS.
LEARNING GOAL 4.
Recognize the financial needs that must be met with available funds.
A. In business, the
need for operating funds never seems to cease.
1. Continuous sound
financial management is essential because the CAPITAL NEEDS OF BUSINESS CHANGE
OVER TIME.
2. Funds must be
available to finance specific operational needs.
B. MANAGING DAILY
BUSINESS OPERATIONS.
1. Funds must be
made available to meet these daily cash expenditures without compromising the
investment potential of the firm's money.
2. Money has TIME
VALUE-$200 today is more valuable that $200 a year from today.
3. Financial
managers often try to keep cash expenditures to a minimum to free funds for
investment in interest-bearing accounts.
4. Efficient cash
management is particularly important to small firms.
C. MANAGING
ACCOUNTS RECEIVABLE.
1. Making credit
available helps keep current customers happy and attracts new customers.
2. The major
problem with credit purchasing is that as much as 25% OF A COMPANY'S ASSETS CAN
BE TIED UP IN ACCOUNTS RECEIVABLE.
3. The firm needs
to use some of its available funds to pay for the goods or services already
given to customers.
4. In order to
collect this money as soon as possible, financial managers offer such
INCENTIVES as cash or quantity discounts to purchasers who pay their account by
a certain time.
5. One way to
decrease the time and expense of collecting accounts receivable is to ACCEPT
BANK CREDIT CARDS such as MasterCard or Visa.
D. OBTAINING NEEDED
INVENTORY.
1. To satisfy
customers, businesses must maintain INVENTORIES that involve a sizable
expenditure of funds.
2. A carefully
constructed inventory policy assists in managing the use of the firm's
available funds and maximizing profitability.
3. JIT INVENTORY
may help reduce the funds companies must use to maintain inventories.
E. MAJOR CAPITAL
EXPENDITURES.
1. CAPITAL
EXPENDITURES are major investments in long-term assets such as land, buildings,
equipment, or research and development.
2. The purchase of
major assets require huge expenditures.
a. It is critical
that the firm weigh all possible options before it commits a large portion of
its available resources.
b. Financial
managers must evaluate the appropriateness of capital expenditures.
V. ALTERNATIVE
SOURCES OF FUNDS.
LEARNING GOAL 5.
Distinguish between short-term and long-term financing and between debt capital
and equity capital.
A. SHORT-TERM
VERSUS LONG-TERM FUNDS.
1. SHORT-TERM
FINANCING refers to the need for capital that will be repaid within one year
and helps finance current operations.
2. LONG-TERM
FINANCING refers to capital needs for major purchases that will be repaid over
a specific time period longer than one year.
B. METHODS OF
RAISING CAPITAL.
1. DEBT CAPITAL
refer to funds raised through various forms of borrowing that must be repaid.
2. EQUITY CAPITAL
is money raised from within the firm or through the sale of ownership in the
firm.
VI. OBTAINING
SHORT-TERM FINANCING.
LEARNING GOAL
6.Identify and describe several sources of short-term financing.
A. Everyday
operation of the firm calls for careful management of short-term financial
needs.
B. TRADE CREDIT.
1. The most widely
used source of short-term funding, trade credit, is the least expensive and
most convenient form of short-term financing.
2. TRADE CREDIT is
the practice of buying goods now and paying for them later or paying for them
early and getting a discount.
3. Terms such as
'2/10, net 30' means that the buyer can take a 2 percent discount for paying
within 10 days and the total bill is due in 30 days if the discount is not
taken.
C. PROMISSORY
NOTES.
1. For
organizations with a poor credit rating or history of slow payment, the
supplier may insist that the customer sign a promissory note.
2. A PROMISSORY
NOTE is a written contract with a promise to pay.
D. FAMILY AND
FRIENDS.
1. It is better not
to borrow from friends and relatives.
2. Entrepreneurs
have come to rely less and less on family and friends for funding.
3. If you borrow
from family or friends it is best to:
a. AGREE ON TERMS
AT THE BEGINNING.
b. WRITE AN
AGREEMENT.
c. PAY THEM BACK
THE SAME WAY YOU WOULD A BANK LOAN.
E. COMMERCIAL BANKS
AND OTHER FINANCIAL INSTITUTIONS.
1. Banks are highly
sensitive to risk and often reluctant to loan money to small business.
a. The most
promising ventures are some times able to get bank loans.
b. The person in
charge of finance should keep in close touch with the bank and see the banker
periodically.
c. How much a
business borrows and for how long depend on the kind of business it is and how
quickly the merchandise purchased with a bank loan can be resold or used to
generate funds.
d. Sometimes a
business gets so far into debt that the bank refuses to lend it more funds.
(i) Often the
business fails.
(ii) This result
can be chalked up to cash flow problems.
e. By anticipating
times when many bills will come due, a business can begin early to seek funds
and prepare for the crunch.
2. DIFFERENT FORMS
OF BANK LOANS.
a. UNSECURED LOANS,
loans that are not backed by collateral, are the most difficult to get-only
highly regarded customers are approved.
b. SECURED LOANS
are loans that are backed by collateral.
(i) PLEDGING means
using accounts receivable as security.
(ii) INVENTORY
FINANCING means that inventory is used as collateral.
c. LINE OF CREDIT
means that bank will lend the business a given amount of unsecured short-term
funds, provided the bank has the funds available.
(i) A line of
credit is not guaranteed.
(ii) The purpose of
a line of credit is to speed the borrowing process.
(iii) As businesses
mature and become more financially secure, the amount of credit often is
increased.
(iv) REVOLVING
CREDIT AGREEMENT is a line of credit that is guaranteed.
d. COMMERCIAL
FINANCE COMPANIES make short-term loans to borrowers that offer tangible assets
as collateral.
(i) Commercial
finance companies are willing to accept higher degrees of risk than commercial
banks.
(ii) Interest rates
charged are usually higher than banks.
F. FACTORING.
1. FACTORING, the
process of selling ac counts receivable for cash, is relatively expensive.
2. A FACTOR is a
market intermediary that agrees to buy the accounts receivable from the firm at
a discount for cash.
3. The factor then
collects and keeps the money that was owed the firm.
4. Factoring is
very popular among small businesses.
5. Factoring is not
a loan-it is the sale of an asset.
6. Factoring
charges are much lower if the company assumes the risk of those accounts who
don't pay at all.
G. COMMERCIAL
PAPER.
1. COMMERCIAL PAPER
consists of unsecured promissory notes in amounts of $25,000 and up that mature
in 270 days or less.
2. Commercial paper
is unsecured and is sold at a public sale, so only financially stable firms are
able to sell it.
VII. OBTAINING
LONG-TERM FINANCING.
LEARNING GOAL 7.
Identify and describe several sources of long-term financing.
A. The financial
plan specifies the amount of funding that the firm will need over various time
periods and the most appropriate sources of those funds.
1. In setting
long-term financing objectives, the firm generally asks three major questions:
a. What are the
organization's long-term GOALS AND OBJECTIVES?
b. What are the
FINANCIAL REQUIREMENTS needed to achieve these goals and objectives?
c. What SOURCES of
long-term capital are available, and which best fit our needs?
2. LONG-TERM
CAPITAL is used to buy fixed assets such as plant and equipment and to finance
any expansions of the organization.
3. Long-term
financing usually comes from two sources: DEBT CAPITAL or EQUITY CAPITAL.
B. DEBT FINANCING.
1. DEBT CAPITAL are
funds that come to the firm from borrowing through lending institutions or from
the sale of bonds.
a. With debt
financing, the company has a legal obligation to repay the amount borrowed.
b. Long-term loans
are usually repaid within 3 to 7 years, but may extend to 15 or 20 years.
c. A TERM-LOAN
AGREEMENT is a promissory note that requires the borrower to repay the loan in
specified installments.
d. A major
advantage is that interest paid on a long-term debt is tax deductible.
2. LONG-TERM LOANS
are often more expensive than short-term loans because larger amounts of
capital are borrowed and the repayment date is less secure.
a. Most long-term
loans require some form of COLLATERAL.
b. Lenders will
also often require certain RESTRICTIONS on a firm's operations.
c. The greater risk
a lender takes in making a loan, the higher rate of interest it requires, known
as the RISK/RETURN TRADEOFF.
3. If an
organization is unable to obtain its long-term financing needs from a lending
institution, it may decide to issue bonds.
a. A BOND is a
company IOU, a binding contract through which an organization agrees to
specific terms with investors in return for investors lending money to the
company.
b. INDENTURE TERMS
are the terms of agreement in a bond.
4. SECURED AND
UNSECURED BONDS.
a. A BOND is a
long-term debt obligation of a corporation or government.
b. Investors in
bonds measure the RISK involves in purchasing a bond with the RETURN (interest)
the bond promises to pay.
c. SECURED BONDS
are issued with some form of collateral, such as real estate, equipment, or
other pledged collateral, such as real estate, equipment, or other pledged
assets.
d. UNSECURED BONDS
are bonds backed only by the reputation of the organization and bondholders'
trust in the issuer.
C. EQUITY
FINANCING.
1. EQUITY FINANCING
comes from the owners of the firm.
a. It involves
selling ownership in the firm in the form of stock, or using retained earnings
the firm has reinvested in the business.
b. A business can
also seek equity financing from venture capital.
2. SELLING STOCK.
a. One way to
obtain need funds is to sell OWNERSHIP SHARES (STOCK) in the firm to the
public.
b. Purchasers of
stock become OWNERS in the organization.
c. Shares of stock
the company decides not to offer for sale are known as UNISSUED STOCK.
d. Companies can
only issue stock for public purchase if they meet requirements set by the Security
and Exchange Commission (SEC.)
e. The terminology
and intricacies of selling stock to raise funds is discussed in the next
chapter.
D. RETAINED
EARNINGS is the profit the company keeps and reinvests in the firm.
1. This is often a
major source of long-term funds.
2. Retained
earnings are usually the most favored source of meeting long-term capital needs
because:
a. The company
saves interest payments, dividends, and underwriting fees.
b. There is no
dilution of ownership.
3. The major
problem is that many organizations do not have sufficient retained earnings.
E. VENTURE CAPITAL.
1. The hardest time
for a business to raise money is when it is just starting.
2. Venture capital
firms are one of the sources of start-up capital for new companies.
3. Venture capital
money is invested in new companies with great profit potential.
4. The venture
capital industry began about 50 years ago as an alternative investment vehicle
for wealthy families.
a. The venture capital
industry grew significantly in the 1980s.
b. For the
fastest-growing firms, the number one source of funds is venture capital.
5. The venture
capital firm generally wants a stake in the ownership of business and expect a
very high return on their investment.
6. The search for
venture capital begins with a good business plan.
7. Financing a
firm's long-term needs clearly involves a high degree of risk.
F. MAKING DECISIONS
ON USING LEVERAGE.
1. LEVERAGE is
raising needed funds through borrowing to increase the firm's rate of return.
2. While debt
increases the risk of the firm, it also enhances the firm's ability to increase
profitability.
3. If the firm's
earnings are larger than the interest payments on the funds borrowed,
stockholders earn a higher rate of return than if equity financing were used.
4. It is up to each
firm to determine exactly what is a proper balance between debt and equity
financing.
5. The average debt
of a large industrial corporation ranges between 33 and 40% of its total
assets.
G. The next chapter
looks at stocks and bonds and other investment topics both as financing tools
and as investment options.