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.

Copyright © Houghton Mifflin Company. All rights reserved.20 | 3 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 4 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 5 Cash Flow for a Manufacturing Business

Copyright © Houghton Mifflin Company. All rights reserved.20 | 6 Comparison of Short- and Long-Term Financing

Copyright © Houghton Mifflin Company. All rights reserved.20 | 7 The Need for Financial Management 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 –Excess cash is invested in interest-bearing securities

Copyright © Houghton Mifflin Company. All rights reserved.20 | 8 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 Careers in Finance

Copyright © Houghton Mifflin Company. All rights reserved.20 | 9 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 –Budgeting for financial needs –Identifying sources of funds

Copyright © Houghton Mifflin Company. All rights reserved.20 | 10 The Three Steps of Financial Planning

Copyright © Houghton Mifflin Company. All rights reserved.20 | 11 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 12 Developing the Financial Plan (cont’d) Budgeting for financial needs –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 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 Estimates a firm’s expenditures for major assets and its long-term financing needs

Copyright © Houghton Mifflin Company. All rights reserved.20 | 13 Sales Budget for Stars and Stripes Clothing

Copyright © Houghton Mifflin Company. All rights reserved.20 | 14 Cash Budget for Stars and Stripes Clothing

Copyright © Houghton Mifflin Company. All rights reserved.20 | 15 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 –Proceeds from the sale of assets If absolutely necessary or when no longer needed Monitoring and evaluating financial performance –Prevents minor problems from becoming major ones

Copyright © Houghton Mifflin Company. All rights reserved.20 | 16 Short-Term Debt Financing Short-term financing is usually easier to obtain than long-term –Shorter repayment period means less risk of nonpayment –Amounts of short-term loans are smaller than long-term loans –There is a closer relationship between borrower and lender

Copyright © Houghton Mifflin Company. All rights reserved.20 | 17 Sources of Unsecured Short-Term Debt Financing Unsecured financing –Financing not backed by collateral Trade credit –Financing extended by a seller who does not require immediate payment after the delivery of the merchandise Promissory notes –A written pledge by a borrower to pay a certain sum of money to a creditor at a specified future date –Unlike trade credit, promissory notes usually include interest –Legally binding –Negotiable instruments

Copyright © Houghton Mifflin Company. All rights reserved.20 | 18 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 Commercial paper –Short-term promissory note issued by a large corporation –Interest rates are usually below that charged by banks for short-term loans

Copyright © Houghton Mifflin Company. All rights reserved.20 | 19 Average Prime Interest Rate

Copyright © Houghton Mifflin Company. All rights reserved.20 | 20 Sources of Secured Short-Term Debt Financing Loans secured by inventory –Inventory is pledged as collateral –Control of the inventory passes to the lender until the loan is repaid –The borrow must pay storage for the inventory –Floor planning The title to the inventory is given to lenders in return for short-term financing The borrow maintains control of the inventory Loans secured by receivables –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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 21 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 22 Comparison of Short-Term Financing Methods

Copyright © Houghton Mifflin Company. All rights reserved.20 | 23 Sources of Equity 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 24 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 25 Sources of Equity Financing (cont’d) 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 –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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 26 Sources of Equity Financing (cont’d) Retained earnings –The portion of a corporation’s profits not distributed to stockholders 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 27 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 28 Effects of Additional Capital

Copyright © Houghton Mifflin Company. All rights reserved.20 | 29 Sources of Long-Term Debt Financing (cont’d) Long-term loans –Term-loan agreement For loans longer than 1 year 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 30 Sources of Long-Term Debt Financing (cont’d) Corporate bonds –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 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 31 Sources of Long-Term Debt Financing (cont’d) Corporate bonds (cont’d) –Repayment provisions for corporate bonds 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 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

Copyright © Houghton Mifflin Company. All rights reserved.20 | 32 Comparison of Long-Term Financing Methods