chapter twenty mastering financial management. copyright © houghton mifflin company. all rights...

Chapter Twenty

Mastering Financial

Management

Copyright © Houghton Mifflin Company. All rights reserved. 20 - 2

Learning Objectives

1. Explain the need for financing and financial management in business.

2. Summarize the process of planning for financial management

3. Describe the advantages and disadvantages of different methods of short-term debt financing.

4. Evaluate the advantages and disadvantages of equity financing.

5. Evaluate the advantages and disadvantages of long-term debt financing.


LO 1: What Is Financial Management?

• All the activities concerned with obtaining money and using it effectively– Determining the best ways to raise money– Ensuring money is used in keeping with

the organization’s goals– Planning

• The need for financing– When expenses are high or sales are low– Opportunities to expand


The Need for Financing

• Short-term financing– Money that will be used for one year or

less• Cash flow—the movement of money into and

out of an organization• Inventory—’speculative production’ (the time

lag between the actual production of goods and when the goods are sold)

• Long-term financing– Money that will be used for longer than one

year– Often involves large amounts of money


Cash Flow for a Manufacturing Business


The Need for Financial Management

• Financing gets business started then it supports on-going activities

• Proper financial management can ensure that– Financing priorities are in line with

organizational goals and objectives– Spending is planned and controlled– Sufficient financing is available when it is

needed (and obtained at lowest cost)– Excess cash is invested in interest-bearing

securities


Careers in Finance• Skills and traits of successful financial managers

– Responsible and honest– Strong background in accounting or math– Knowledge of how to use a computer to analyze data– Expert in written and oral communications

• Jobs– Bank officer– Credit officer– Financial analyst– Financial planner– Insurance analyst– Investment account executive


LO 2: Planning—The Basis of Sound Financial Management

• Financial plan– A plan for obtaining and using the money needed

to implement an organization’s goals

• Developing the financial plan– Establishing organizational goals and objectives

• Specific and measurable ($-costs)

– Budgeting for financial needs• Projects income & expenses over specific period• First by departments over short period• Combined for company-wide cash budget

– Identifying sources of funds


Developing the Financial Plan

• Establishing goals and objectives– Goal

• An end state that the organization expects to achieve over a 1- to 10-year period

– Objectives• Specific statements detailing what the

organization intends to accomplish within a certain period of time

– Must be specific and measurable– Must be realistic


The Three Steps of Financial Planning


Developing the Financial Plan (cont’d)

• Budgeting for financial needs (p 607)– Budget

• A financial statement that projects income and/or expenditures over a specified future period

• Usually begins with sales and various types of expenses

– Cash budget (short term)• Projects cash receipts and expenditures over a specified

future period• Traditional

– Based on dollar amounts in budget for preceding year

• Zero-based budgeting– Every expense in every budget must be justified

– Capital budget (long-term)• Estimates a firm’s expenditures for major assets and its

long-term financing needs


Sales Budget for Stars and Stripes Clothing


Cash Budget for Stars and Stripes Clothing


Developing the Financial Plan (cont’d)

• Identifying sources of funds– Sales revenues

• Provide the greatest part of the firm’s financing

– Equity capital• Money received from the owners or from the sale of

shares of ownership in the business; long-term financing

– Debt capital• Borrowed money obtained through loans (short or long)

– Proceeds from the sale of assets• If absolutely necessary or when no longer needed

• Monitoring and evaluating financial performance– Interim budgets for comparison

• Prevents minor problems from becoming major ones


LO 3: Short-Term Debt Financing

• Short-term financing is usually easier to obtain than long-term, Why?

1. Shorter repayment period means less risk of nonpayment

2. Amounts of short-term loans are smaller than long-term loans

3. There is a closer relationship between borrower and lender


Collateral

• Most lenders do not require collateral for short-term financing

• But sometimes, they do:– Concerned about size of loan– Poor credit rating– General prospects about repayment


Sources of Unsecured Short-Term Debt Financing

• Unsecured financing– Financing not backed by collateral

• Unsecured financing Options:– Trade credit

• Financing extended by a seller who does not require immediate payment after the delivery of the merchandise

• Most popular type: 80-90% of all transactions)• Invoice that states credit terms, 30-60 days• Cash discount: 2/10 N/30

– Promissory notes (p 611)• A written pledge by a borrower to pay a certain sum of

money to a creditor at a specified future date (60-180 days)

• Unlike trade credit, promissory notes usually include interest

• Legally binding, negotiable (can be sold) instruments


Sources of Unsecured Short-Term Debt Financing (cont’d)

• Unsecured bank loans– Interest rates vary with each borrower’s credit rating– Prime interest rate

• The lowest rate charged by a bank for a short-term loan– Offered through promissory notes, a line or credit, or

revolving credit agreement• Bank may require ‘compensating’ balance (20%)• Bank may require yearly ‘clean-up’ (pay off completely)• Revolving Credit ($ available when needed)

– Commitment fee of .25 to 1% of unused portion– Usual interest for portion borrowed

• Commercial paper– Short-term promissory note issued by a large corporation– Secured only by reputation of issuing firm, no collateral– Interest rates are usually below that charged by banks for

short-term loans– Large firms with excellent credit ranking can quickly raise $– But not without risks

http://www.nfsn.com/library/prime.htm


Sources of Secured (Collateral) Short-Term Debt Financing

• Loans secured by inventory– Inventory is pledged as collateral (salable)– Control (public warehouse) of the inventory

passes to the lender until the loan is repaid– The borrow must pay storage for the inventory– Floor planning (auto, furniture, applicance)

• The title to the inventory is given to lenders in return for short-term financing

• The borrower maintains control of the inventory

• Loans secured by receivables (70-80%)– Amounts owed the firm in the form of accounts

receivable from trade credit given to customers are pledged as collateral

– Quality of receivables is considered


Factoring Accounts Receivable

• Another method of raising short-term financing• Factor

– A firm that specializes in buying other firms’ accounts receivable

• The factor buys accounts receivable for less than their face value

• The factor collects the full dollar amounts when each account is due

• The factor’s profit is the difference between the face value and what it paid for the accounts receivable

• Profit is based on the risk (probability that the accounts receivable will not be paid) the factor assumes


LO 4: Sources of Equity (Long-term) Financing

• For sole proprietorships or partnerships– Owner or owners invest money in the

business– Venture capital

• For corporations– Sale of stock– Use of profits not distributed to owners– Venture capital


Sources of Equity Financing (cont’d)

• Selling stock– Initial public offering

• When a corporation sells common stock to the general public for the first time

– Advantages of selling stock• Firm does not have to repay money received

from sale of stock• Firm does not have to pay dividends to

stockholders

– Two types of stock• Common stock• Preferred stock



• Selling stock (cont’d)– Common stock

• Stock whose owners may vote on corporate matters but whose claims on profits and assets are subordinate to the claims of others

– Preferred stock• Stock whose owners usually do not have voting rights, but

whose claims on dividends and assets are paid before those of common-stock owners

– Dividend stated on stock certificate– Callable (buy back when can issue new preferred at a lower

dividend rate)– Par value

• An assigned (and often arbitrary) dollar value printed on a stock certificate

– Convertible preferred stock• Preferred stock that the owner may exchange for a specified

number of shares of common stock



• Retained earnings– The portion of a corporation’s profits not

distributed to stockholders– Small & growing firms don’t pay dividends

• Venture capital– Money invested in a firm with the

expectation that the firm has the potential to become very successful and increase in value

– Investors usually receive an equity position in the business and share in its profits


LO 5: Sources of Long-Term Debt Financing

• Financial leverage– The use of borrowed funds to increase the return

on owners’ equity– As long as the firm’s earnings are larger than the

interest charged for the borrowed money, there is a positive effect on return on owners’ equity

• Lease– An agreement by which the right to use real

estate, equipment, or other assets is temporarily transferred from the owner to the user

– Sometimes used if a firm cannot obtain a loan to acquire property, buildings, or equipment

– Can have tax advantages over long-term debt financing


Sources of Long-Term Debt Financing (cont’d)

• Long-term loans (banks, insurance, pension)– Term-loan agreement

• For loans longer than 1 year (usually 3-7)• A promissory note that requires a borrower to repay a loan

in monthly, quarterly, semiannual, or annual installments

– Interest rate and repayment terms are based on the reasons for borrowing, the firm’s credit rating, the value of collateral

– Getting a loan• Know potential lenders• Maintain a good credit rating• Fill out an application; submit a business plan and

financial statements; compile references• Meet with loan officer• If denied, determine why



• Corporate bonds (p 622)– A corporation’s written pledge that it will repay a

specified amount of money with interest– Maturity date—the date on which the corporation is

to repay the borrowed money– Interest is paid until maturity– Types of bonds

• Registered bond—a bond registered in the owner’s name by the issuing company (most common)

• Debenture bond—a bond backed only by the reputation of the issuing corporation

• Mortgage bond—a bond secured by various assets of the issuing firm

• Convertible bond—a bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock (usually lower interest rate)



• Corporate bonds (cont’d)– Repayment provisions for corporate bonds

• 10-30 Years, default can force into bankruptsy• Bond indenture—a legal document that details all the

conditions relating to a bond issue• Call premium—an amount paid to the bond owner if the

corporation buys back the bond before the maturity date• Serial bonds—bonds of a single issue that mature on

different dates (ensures sufficient $)• Sinking fund—a sum of money to which deposits are

made each year for the purpose of redeeming a bond issue

• Trustee—an individual or an independent firm that acts as the bond owners’ representative

chapter twenty mastering financial management. copyright © houghton mifflin company. all rights...

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