- THE ROLE OF FINANCE.
- COMPARING THE
ACCOUNTANT AND THE FINANCIAL MANAGER.
- The role of an
ACCOUNTANT is like a skilled technician who takes measures of a
company’s health and writes a report.
- FINANCIAL
MANAGERS examine the data
prepared by accountants and make recommendations to top management
regarding STRATEGIES FOR IMPROVING THE COMPANY’S FINANCIAL
STRENGTH.
- A manager cannot
make sound financial decisions without understanding accounting
information.
- The need for
careful financial management remains an ongoing challenge in a business
throughout its life.
- The MOST COMMON
WAYS FOR FIRMS TO FAIL FINANCIALLY are:
-
UNDERCAPITALIZATION,
or not enough funds to start with.
- POOR CASH FLOW,
or cash in minus cash out.
- INADEQUATE
EXPENSE CONTROL.
- THE IMPORTANCE OF
UNDERSTANDING FINANCE.
- The text describes
a small organization called Parsley Patch, begun on a shoestring budget.
- When the owners
expanded into the health-food market, sales took off.
-
Neither woman understood cash flow
procedures or how to
control expenses, and profits did not materialize.
- They eventually
hired a CPA and an experienced financial manager, and soon they earned a
comfortable margin on operations.
- Financial
understanding is important to anyone who wants to invest in stocks and bonds
or plan a retirement fund.
- WHAT IS
FINANCIAL MANAGEMENT?
- 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.
- Without a carefully
calculated business plan, the firm has little chance for survival.
- FINANCIAL
MANAGEMENT is the job of
managing a firm’s resources so it can meet its goals and objectives.
- Most
organizations will designate a manager in charge of financial
operations, generally the CHIEF FINANCIAL OFFICER (CFO.)
- Financial
management could also be put in the hands of the company TREASURER
or vice president of finance.
- A COMPTROLLER
is the chief accounting officer.
- The fundamental
task is to obtain money and then plan, use, and control that money
effectively.
- Both CREDIT
and COLLECTIONS are important responsibilities of financial managers.
- Financial managers
are responsible for collecting overdue payments and minimizing bad debts.
- These functions are
particularly critical to small and medium-size businesses, which have
smaller cash or credit cushions.
- Financial managers
also handle TAX MANAGEMENT, the analyzing of tax implications of
various managerial decisions in an attempt to minimize the taxes paid by the
business.
- As tax laws change,
finance specialists must carefully analyze the tax implications of various
decisions in an attempt to minimize taxes paid.
- Businesses of all
sizes must concern themselves with managing taxes.
- 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.
- Without such
audits, accounting statements would be less reliable.
- It is important
that internal auditors be objective and critical of any improprieties or
deficiencies.
- Accounting and
finance are MUTUALLY SUPPORTIVE functions in a firm.
- FINANCIAL
PLANNING.
- Financial planning
involves analyzing short-term and long-term money flows to and from the
firm.
- The major objective
of financial planning is TO OPTIMIZE PROFITS AND MAKE THE BEST USE OF
MONEY.
- The steps involved
in FINANCIAL PLANNING are:
- The steps
involved in FINANCIAL PLANNING are:
- DEVELOPING
BUDGETS to meet those needs.
- ESTABLISHING
FINANCIAL CONTROL to see how
well the company is following the financial plans.
- FORECASTING
FINANCIAL NEEDS.
- A SHORT-TERM
FORECAST is a prediction of revenues, costs, and expenses for a period
of one year or less.
- A CASH FLOW
FORECAST is a prediction of cash inflows and outflows in future
periods, usually months or quarters.
- The inflows and
outflows of cash are based on expected sales revenues and on various
costs and expenses.
- A firm often uses
its past financial statements as a basis for projecting expected sales
and various costs and expenses.
- 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.
- This forecast
plays a crucial part in the company’s long-term strategic plan.
- The long-term
financial forecast gives managers an idea of the income or profit
potential with different strategic plans.
- WORKING WITH THE
BUDGET PROCESS.
- A BUDGET is
a financial plan.
- A budget becomes
the primary basis and guide for the firm’s financial operations.
- Most firms
compile yearly budgets from short-term and long-term financial
forecasts.
- There are
SEVERAL BUDGETS IN A COMPANY:
- The CAPITAL
BUDGET highlights a firm’s spending plans for major assets purchased
that required large sums of money.
- The CASH
BUDGET estimates a firm’s projected cash balance at the end of given
period.
- The OPERATING
BUDGET, or MASTER BUDGET, ties together all of a firm’s other
budgets; it is the projection of dollar allocations to various costs and
expenses needed to run the business.
- Financial planning
often determines:
- What long-term
investments are made.
- When specific
funds will be needed.
- How the funds
will be generated.
- ESTABLISHING
FINANCIAL CONTROLS.
- FINANCIAL
CONTROL is a
proces in which a firm periodically compares
its actual revenues, costs, and expenses to those projected.
- Most companies hold
at least monthly financial reviews as a way to ensure financial control.
- Such controls
provide feedback to help reveal which accounts are varying from the
financial plans.
- Some financial
adjustments to the plan may be made.
- THE NEED FOR
OPERATING FUNDS.
- In business, the need
for operating funds never seems to cease.
- Continuous sound
financial management is essential because the CAPITAL NEEDS OF
BUSINESS CHANGE OVER TIME.
- Funds must be
available to finance specific operational needs.
- MANAGING DAILY
BUSINESS
OPERATIONS.
- Funds must be made
available to meet these daily cash expenditures without compromising the
investment potential of the firm’s money.
- Money has TIME
VALUE—$200 today is more valuable that $200 a year from today.
- Financial managers
often try to keep cash expenditures to a minimum to free funds for
investment in interest-bearing accounts.
- Efficient cash
management is particularly important to small firms.
- MANAGING ACCOUNTS
RECEIVABLE.
- Making credit
available helps keep current customers happy and attracts new ones.
- The major problem
with credit purchasing is that as much as 25% OF A COMPANY’S ASSETS CAN BE
TIED UP IN ACCOUNTS RECEIVABLE.
- The firm needs to
use some of its available funds to pay for the goods or services already
given to customers.
- 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.
- One way to decrease
the time and expense of collecting accounts receivable is to ACCEPT
BANK CREDIT CARDS such as MasterCard or Visa.
- OBTAINING NEEDED
INVENTORY.
- To satisfy
customers, businesses must maintain INVENTORIES that involve a
sizable expenditure of funds.
- A carefully
constructed inventory policy assists in managing the use of the firm’s
available funds and maximizing profitability.
- JUST-IN-TIME
INVENTORY may help reduce the
funds companies must use to maintain inventories.
- MAJOR CAPITAL
EXPENDITURES.
- CAPITAL
EXPENDITURES are major
investments in long-term assets such as land, buildings, equipment, or
R&D.
- The
purchase of major assets require huge
expenditures.
- It is critical
that the firm weigh all possible options before it commits a large
portion of its available resources.
- Financial
managers must evaluate the appropriateness of capital expenditures.
- ALTERNATIVE SOURCES
OF FUNDS.
- SHORT-TERM VERSUS
LONG-TERM FUNDS.
- SHORT-TERM
FINANCING refers to borrowed
capital that will be repaid within one year and helps finance current
operations.
- LONG-TERM
FINANCING refers to borrowed
capital for major purchases that will be repaid over a specific time
period longer than one year.
- METHODS OF RAISING
CAPITAL.
- DEBT CAPITAL
refer to funds raised through various forms of
borrowing that must be repaid.
-
EQUITY CAPITAL
is money raised from within the firm or through the sale of ownership in
the firm.
- OBTAINING SHORT-TERM
FINANCING.
- Everyday operation of
the firm calls for careful management of short-term financial needs.
- TRADE CREDIT.
- The most widely
used source of short-term funding, trade credit, is the least expensive
and most convenient form of short-term financing.
- TRADE CREDIT
is the practice of buying
goods now and paying for them later or paying for them early and getting a
discount.
- 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.
- PROMISSORY NOTES.
- For organizations
with a poor credit rating or history of slow payment, the supplier may
insist that the customer sign a promissory note.
- A PROMISSORY
NOTE is a written contract with a promise to pay.
- FAMILY AND FRIENDS.
- It is better not to
borrow from friends and relatives.
- Entrepreneurs have
come to rely less and less on family and friends for funding.
- If you borrow from
family or friends it is best to:
- AGREE ON
SPECIFIC LOAN TERMS AT THE BEGINNING.
- PUT THE
AGREEMENT IN WRITING.
- ARRANGE FOR
REPAYMENT IN THE SAME WAY YOU WOULD A BANK LOAN.
- COMMERCIAL BANKS
AND OTHER FINANCIAL INSTITUTIONS.
- Banks are highly
sensitive to risk and often reluctant to loan money to small business.
- The most
promising ventures are sometimes able to get bank loans.
- The person in
charge of finance should keep in close touch with the bank and see the
banker periodically.
- How much a
business borrows and for how long depend on:
- The kind of
business it is.
- How quickly the
merchandise purchased with a bank loan can be resold or used to
generate funds.
- Sometimes a
business gets so far into debt that the bank refuses to lend it more
funds.
- Often the
business fails.
- This result can
be chalked up to cash flow problems.
- By anticipating
times when many bills will come due, a business can begin early to seek
funds and prepare for the crunch.
- A banker’s advice
at this point can help the firm.
- DIFFERENT FORMS OF
BANK LOANS.
- A SECURED LOAN
is a loan that’s backed by something valuable, such as property.
- The item of value
is called COLLATERAL.
- Accounts
receivable can be quickly converted into cash, and are often used as
security.
- The process of
using accounts receivable or other assets as collateral for a loan is
PLEDGING.
-
INVENTORY FINANCING
is the process of using inventory such as raw materials as
collateral for a loan.
- UNSECURED LOANS,
loans that are not backed by collateral, are the most difficult to
get—only highly regarded customers are approved.
- 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.
- A line of credit
is not guaranteed.
- The purpose of a
line of credit is to speed the borrowing process.
- As businesses
mature and become more financially secure, the amount of credit often is
increased.
- REVOLVING
CREDIT AGREEMENT is a line
of credit that is guaranteed.
- COMMERCIAL
FINANCE COMPANIES make
short-term loans to borrowers that offer tangible assets as collateral.
- Commercial
finance companies are willing to accept higher degrees of risk than
commercial banks.
- Interest rates
charged are usually higher than banks.
- FACTORING.
- FACTORING,
the process of selling accounts receivable for cash, is relatively
expensive.
- A FACTOR is
a market intermediary that agrees to buy the accounts receivable from the
firm at a discount for cash.
- The factor then
collects and keeps the money that was owed the firm.
- Factoring is very
popular among small businesses.
- Factoring is not a
loan—it is the sale of an asset.
- Factoring charges
are much lower if the company assumes the risk of those accounts
who don’t pay at all.
- COMMERCIAL PAPER.
- COMMERCIAL PAPER
consists of unsecured promissory notes in amounts of $25,000 and up that
mature in 270 days or less.
- Commercial paper is
unsecured and is sold at a public sale, so ONLY FINANCIALLY STABLE
FIRMS are able to sell it.
- Some large
companies are considering selling commercial paper over the Internet.
- It is an investment
opportunity for buyers who can put up cash for short periods.
- OBTAINING LONG-TERM
FINANCING.
- 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.
- In setting
long-term financing objectives, the firm generally asks three major
questions:
- What
are the organization’s long-term GOALS AND
OBJECTIVES?
- What are the
FINANCIAL REQUIREMENTS needed to achieve these goals and objectives?
- What SOURCES
of long-term capital are available, and which best fit our needs?
- LONG-TERM
CAPITAL is used to buy fixed
assets such as plant and equipment and to finance any expansions of the
organization.
- Long-term financing
usually comes from two sources: DEBT CAPITAL or
EQUITY CAPITAL.
- DEBT FINANCING.
- DEBT CAPITAL
are funds that come to the firm from borrowing
through lending institutions or from the sale of bonds.
- With debt
financing, the firm has a legal obligation to repay the amount
borrowed.
- Long-term loans
are usually repaid within 3 to 7 years, but may extend to 15 or 20
years.
- A TERM-LOAN
AGREEMENT is a promissory note that requires the borrower to repay
the loan in specified installments.
- A major advantage
is that interest paid on a long-term debt is tax deductible.
- 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.
- Most long-term
loans require some form of COLLATERAL.
- Lenders will also
often require certain RESTRICTIONS on a firm’s operations.
- The greater risk
a lender takes, the higher rate of interest it requires, known as the
RISK/RETURN TRADEOFF.
- If an organization
is unable to obtain its long-term financing needs from a lending
institution, it may decide to issue bonds.
- 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.
- INDENTURE
TERMS are the terms of
agreement in a bond.
- SECURED AND
UNSECURED BONDS.
- A BOND is a
long-term debt obligation of a corporation or government.
- Investors in bonds
measure the RISK involves in purchasing a bond with the RETURN
(interest) the bond promises to pay.
- 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.
- UNSECURED BONDS
are bonds backed only by the reputation of the organization and
bondholders’ trust in the issuer.
- EQUITY FINANCING.
- EQUITY FINANCING
comes from the owners of the firm.
- It involves selling
ownership in the firm in the form of stock, or using retained earnings the
firm has reinvested in the business.
- A business can also
seek equity financing from venture capital.
- SELLING STOCK.
- One way to obtain
need funds is to sell OWNERSHIP SHARES (STOCK) in the firm to the
public.
- Purchasers of stock
become OWNERS in the organization.
- Shares of stock the
company decides not to offer for sale are known as
UNISSUED STOCK, or TREASURY STOCK.
- Companies can only
issue stock for public purchase if they meet requirements set by the
Security and Exchange Commission (SEC.)
- The terminology and
intricacies of selling stock to raise funds is discussed in the next
chapter.
- RETAINED EARNINGS
is the profit the company keeps and reinvests in the firm.
- This is often a
MAJOR SOURCE OF LONG-TERM FUNDS.
- Retained earnings
are usually the most favored source of meeting long-term capital needs
because:
- The company saves
interest payments, dividends, and underwriting fees.
- There is no
dilution of ownership.
- The major problem
is that many organizations do not have sufficient retained earnings.
-
VENTURE CAPITAL.
- The hardest time
for a business to raise money is when it is just starting.
- Venture capital
firms are one of the sources of start-up capital for new companies.
- VENTURE CAPITAL
MONEY is invested in new
companies with great profit potential.
- The venture capital
industry began about 50 years ago as an alternative investment vehicle for
wealthy families.
- The venture
capital industry grew significantly in the 1980s.
- In the 1990s,
venture capital investment increased, especially in high-tech centers.
- Venture
capitalist investments have recently reached into international markets.
- Venture capitalist
investments have recently reached into international markets.
- The search for
venture capital begins with a good business plan.
- Financing a firm’s
long-term needs clearly involves a high degree of risk.
- MAKING DECISIONS
ON USING LEVERAGE.
- LEVERAGE
is raising needed funds through borrowing to increase the rate of return.
- While debt
increases the risk of the firm, it also enhances the firm’s profitability.
- 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.
- It is up to each
firm to determine exactly what is a proper balance
between debt and equity financing.
- The average debt of
a large industrial corporation ranges between 33 and 40% of its total
assets.
- The next chapter
looks at stocks and bonds and other investment topics.