Financial Management Chapter 18 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

1. Explain the role and responsibilities of financial managers. 2. Outline the financial planning process, and explain the three key budgets in the financial plan. 3. Explain why firms need operating funds. 4. Identify and describe different sources of short- term financing. 5. Identify and describe different sources of long-term financing. LEARNING GOALS Chapter Eighteen 18-2

Finance -- The function in a business that acquires funds for a firm and manages them within the firm. Finance activities include:  Preparing budgets  Creating cash flow analyses  Planning for expenditures  Financial Management -- The job of managing a firm’s resources to meet its goals and objectives. WHAT’S FINANCE? The Role of Finance and Financial Managers LG1 18-3

Financial Managers -- Examine financial data and recommend strategies for improving financial performance. FINANCIAL MANAGERS LG1 The Role of Finance and Financial Managers Financial managers are responsible for:  Paying company bills  Collecting payments  Staying abreast of market changes  Assuring accounting accuracy 18-4

CFO -- Chief Financial Officer CFP -- Certified Financial Planner CFA -- Chartered Financial Analyst Comptroller -- Chief Accounting Officer WHO’S WHO in FINANCE LG2 Financial Planning 18-5

WHAT FINANCIAL MANAGERS DO LG1 The Role of Finance and Financial Managers 18-6

WHAT WORRIES FINANCIAL MANAGERS Consumer demand for their firm’s products Credit markets and interest rates Financial regulations from the government Volatility of the dollar Foreign competition Environmental regulations Source: CFO Magazine, accessed July LG1 The Role of Finance and Financial Managers 18-7

1) Undercapitalization 2) Poor control over cash flow 3) Inadequate expense control WHY DO FIRMS FAIL FINANCIALLY? The Value of Understanding Finance LG1 18-8

TOP FINANCIAL CONCERNS of COMPANY CFOs - MACRO Consumer demand Federal-government policies Price pressure from competitors Credit markets/interest rates Global financial instability Source: CFO Magazine, July/August LG1 The Value of Understanding Finance 18-9

TOP FINANCIAL CONCERNS of COMPANY CFOs - MICRO Ability to maintain margins Ability to forecast results Maintaining morale/productivity Cost of healthcare Working-capital management Source: CFO Magazine, July/August LG1 The Value of Understanding Finance 18-10

Financial planning involves analyzing short-term and long-term money flows to and from the company. Three key steps of financial planning: 1. Forecasting the firm’s short-term and long-term financial needs. 2. Developing budgets to meet those needs. 3. Establishing financial controls to see if the company is achieving its goals. FINANCIAL PLANNING Financial Planning LG

Short-Term Forecast -- Predicts revenues, costs and expenses for a period of one year or less. Cash-Flow Forecast -- Predicts the cash inflows and outflows in future periods, usually months or quarters. Long-Term Forecast -- Predicts revenues, costs, and expenses for a period longer than one year and sometimes as long as five or ten years. FINANCIAL FORECASTING Forecasting Financial Needs LG

Budget -- Sets forth management’s expectations for revenues and allocates the use of specific resources throughout the firm. Budgets depend heavily on the balance sheet, income statement, statement of cash flows and short-term and long-term financial forecasts. The budget is the guide for financial operations and expected financial needs. BUDGETING Working with the Budget Process LG

Capital Budget -- Highlights a firm’s spending plans for major asset purchases that often require large sums of money. Cash Budget -- Estimates cash inflows and outflows during a particular period like a month or quarter. Operating (Master) Budget -- Ties together all the firm’s other budgets and summarizes its proposed financial activities. TYPES of BUDGETS LG2 Working with the Budget Process 18-14

Financial Control -- A process in which a firm periodically compares its actual revenues, costs and expenses with its budget. ESTABLISHING FINANCIAL CONTROL Establishing Financial Control LG

FACTORS USED in ASSESSING FINANCIAL CONTROL Is the firm meeting its short-term financial commitments? Is the firm producing adequate operating profits on its assets? How is the firm financing its assets? Are the firms owners receiving an acceptable return on their investment? LG2 Establishing Financial Control 18-16

Managing day-by-day needs of the business Controlling credit operations Acquiring needed inventory Making capital expenditures KEY NEEDS for OPERATIONAL FUNDS in a FIRM The Need for Operating Funds LG

HOW SMALL BUSINESSES CAN IMPROVE CASH FLOW Be more aggressive in collecting accounts receivable. Offer customers discounts for paying early. Take advantage of special payment terms from vendors. Raise prices. Use credit cards discriminately. Source: American Express Small Business Monitor. LG3 The Need for Operating Funds 18-18

You’re a new hospital administrator at a small hospital that, like many others, is experiencing financial problems. You suggest discontinuing the hospital’s large stockpile of drugs and shift to ordering them just when they are needed. Some like the idea, but the doctors claim you’re sacrificing patients’ well-being for cash. What do you do? What could be the result of your decision? GOOD FINANCE or BAD MEDICINE? (Making Ethical Decisions) 18-19

Debt Financing -- The funds raised through various forms of borrowing that must be repaid. Equity Financing -- The funds raised from within the firm from operations or through the sale of ownership in the firm (such as stock). Short-Term Financing -- Funds needed for a year or less. Long-Term Financing -- Funds needed for more than a year. USING ALTERNATIVE SOURCES of FUNDS Alternative Sources of Funds LG

WHY FIRMS NEED FINANCING Short-Term FundsLong-Term Funds Monthly expensesNew-product development Unanticipated emergenciesReplacement of capital equipment Cash flow problemsMergers or acquisitions Expansion of current inventoryExpansion into new markets Temporary promotional programsNew facilities LG3 Alternative Sources of Funds 18-21

Trade Credit -- The practice of buying goods or services now and paying for them later. Businesses often get terms 2/10 net 30 when receiving trade credit. Promissory Note -- A written contract agreeing to pay a supplier a specific sum of money at a definite time. TYPES of SHORT-TERM FINANCING Trade Credit LG

Many small firms obtain short-term financing from friends and family. If asking for help from family or friends, it’s important both parties: 1) Agree to specific loan terms 2) Put the agreement in writing 3) Arrange for repayment the same way they would for a bank loan TYPES of SHORT-TERM FINANCING Family and Friends LG

Banks generally prefer to lend short- term money to larger, more established businesses. DIFFICULTY of OBTAINING SHORT-TERM FINANCING Commercial Banks LG4 The recent financial crisis has made it difficult for even promising and well-organized businesses to get loans

Peer-to-peer lending sites like Lending Club match small businesses with lenders and receive a fee for their services.Lending Club Lendio claims to have developed a technology that matches business owners with the right type of business loan and lender.Lendio Lendio also offers services such as a business plan makeover and website design for a fee. EXPLORING the FINANCING UNIVERSE (Spotlight on Small Business) 18-25

Commercial banks offer short-term loans like:  Secured Loans -- Backed by collateral.  Unsecured Loans -- Don’t require collateral from the borrower.  Line of Credit -- A given amount of money the bank will provide so long as the funds are available.  Revolving Credit Agreement -- A line of credit that’s guaranteed but comes with a fee. DIFFERENT FORMS of SHORT-TERM LOANS LG4 Different Forms of Short-Term Loans 18-26

Factoring -- The process of selling accounts receivable for cash. Factors charge more than banks, but many small businesses don’t qualify for loans. Commercial Paper -- Unsecured promissory notes in amounts of $100,000+ that come due in 270 days or less. FACTORING / COMMERCIAL PAPER LG4 Factoring Accounts Receivable 18-27

Rates for small businesses grew almost 30% after the Credit Card Responsibility Accountability and Disclosure Act was passed. Credit cards are convenient but costly for a small business. CREDIT CARDS Credit Cards LG4 Photo Courtesy of: Robert Scoble 18-28

WAYS to RAISE START-UP CAPITAL Seek out a microloan from a microlender Use asset-based lending or factoring Source: Entrepreneur, accessed July Turn to the web and seek out peer-to-peer lendingpeer-to-peer lending Research local banks Sweet-talk vendors you want to do business with LG4 Credit Cards 18-29

Three questions of financial managers in setting long- term financing objectives: 1. What are the organization’s long-term goals and objectives? 2. What funds do we need to achieve the firm’s long-term goals and objectives? 3. What sources of long-term funding (capital) are available, and which will best fit our needs? SETTING LONG-TERM FINANCING OBJECTIVES Obtaining Long-Term Financing LG

1. The character of the borrow. 2. The borrower’s capacity to repay the loan. 3. The capital being invested in the business by the borrower. 4. The conditions of the economy and the firm’s industry. 5. The collateral the borrower has available to secure the loan. The FIVE “C”s of CREDIT LG5 Obtaining Long-Term Financing 18-31

Long-term financing loans generally come due within 3 -7 years but may extend to 15 or 20 years. Term-Loan Agreement -- A promissory note that requires the borrower to repay the loan with interest in specified monthly or annual installments. A major advantage of debt financing is the interest the firm pays is tax deductible. USING LONG-TERM DEBT FINANCING Debt Financing LG

Indenture Terms -- The terms of agreement in a bond issue. Secured Bond -- A bond issued with some form of collateral (i.e. real estate). Unsecured (Debenture) Bond -- A bond backed only by the reputation of the issuing company. USING DEBT FINANCING by ISSUING BONDS LG5 Debt Financing 18-33

A company can secure equity financing by: SECURING EQUITY FINANCING Equity Financing  Selling shares of stock in the company.  Earning profits and using the retained earnings as reinvestments in the firm.  Attracting Venture Capital -- Money that is invested in new or emerging companies that some investors believe have great profit potential. LG

WANT to ATTRACT a VENTURE CAPITALIST? LG5 Equity Financing 1. Can the company grow? 2. Will we get our money back and more? 3. Will it be worth our money and effort? Source: Entrepreneur, February

DIFFERENCES BETWEEN DEBT and EQUITY FINANCING Comparing Debt and Equity Financing Types of Financing ConditionsDebtEquity Management influence None. Unless special conditions have been agreed on. Common stock holders have voting rights. Repayment Debt has a maturity date. Stock has no maturity date. Yearly obligationsPayment of interest. The firm isn’t legally liable to pay dividends. Tax benefits Interest is tax deductible. Dividends are not tax deductible. LG

Leverage -- Raising funds through borrowing to increase the firm’s rate of return. Cost of Capital -- The rate of return a company must earn in order to meet the demands of its lenders and expectations of equity holders. USING LEVERAGE for FUNDING NEEDS LG5 Comparing Debt and Equity Financing 18-37

The recent financial crisis was the worst fall since the Great Depression. LESSONS of the FINANCIAL CRISIS LG5 Lessons From the Financial Crisis Led to the passage of sweeping financial reform. Government is increasing involvement and intervention