Business Principles Chapter 18 Financial Management

Chapter 18 Financial Management The Role of Finance and Financial Managers The function in a business that acquires funds for the firm and manages those funds within the firm. Finance activities include: ● Preparing budgets. ● Doing cash flow analysis. ● Planning for expenditures. Financial Management The job of managing a firm’s resources to meet its goals and objectives. Financial managers — Examine financial data and recommend strategies for improving financial performance. ● Financial managers are responsible for: ● Obtaining funds. ● Effectively controlling use of funds. Who’s Who in Finance? C F O — Chief Financial Officer C F P — Certified Financial Planner C F A — Chartered Financial Analyst Comptroller — Chief Accounting Officer Signs You Need a CFO: 1. You do not have information on key items like cash flow, working capital, or forecasts. 2. No one is carefully watching and analyzing your expenses. 3. You are not aware of regulatory changes that could affect your business. 4. You are unable to generate financial reports. 5. Shareholders are frustrated with the lack of a C F O. What Worries Financial Managers? ● ● ● ● ● ● ● Market unpredictability. Interest rates. Cyberthreats. Financial regulations from the government. Volatility of the dollar. Foreign competition. Environmental regulations. The Role of Finance and Financial Managers The Value of Understanding Finance ● Most common reasons a firm fails financially: 1. Undercapitalization. 2. Poor control over cash flow. 3. Inadequate expense control. What Is Financial Management? ● Financial managers are responsible for paying the company’s bills and collecting overdue payments. ● Finance functions are particularly critical to small- and medium-sized businesses. ● It’s essential that financial managers stay abreast of changes or opportunities in finance, such as changes in tax law. Financial Planning ● Involves analyzing short-term and long-term money flows to and from the company. ● Three key steps: 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. Forecasting Financial Needs 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. Working with the Budget Process ● Budget — Sets forth management’s expectations 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. Types of budgets: ● 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 (or master) budget — Ties together all the firm’s other budgets and summarizes its proposed financial activities. Establishing Financial Controls ● Financial control — A process in which a firm periodically compares its actual revenues, costs, and expenses with its budget. ● Most companies hold at least monthly financial reviews. ● Identifies variances to the financial plan and allows the firm to take corrective action. Factors Used in Assesing 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 firm's owners receiving an acceptable return on their investment? The Need for Operating Funds Key Needs for Operational Funds Managing day-by-day needs of the business. Controlling credit operations. Acquiring needed inventory. Making capital expenditures. ● Capital expenditures — Major investments in either tangible long-term assets such as land, buildings, and equipment or intangible assets such as patents, trademarks, and copyrights. How Small Businesses Can Improve Cash Flow ● ● ● ● ● Raise prices. Be more aggressive in collecting accounts receivable. Offer discounts for paying early. Take advantage of special payment terms from vendors. Use credit cards carefully. The Need for Operating Funds Alternative Sources of Funds ● Debt financing — Funds raised through various forms of borrowing that must be repaid. ● Equity financing — Money raised from within the firm, from operations or through the sale of ownership in the firm (stock or venture capital). ● Short-term financing — Funds needed for a year or less. ● Long-term financing — Funds needed for more than a year. Obtaining Short-Term Financing Trade Credit ● The practice of buying goods and services now and paying for them later. ● Businesses often get terms such as 2/10, net 30 when receiving trade credit. ● Promissory note — A agreement with a promise to pay a supplier a specific sum of money at a definite time. Family and Friends ● 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. Commercial Banks ● Banks generally prefer to lend short-term money to larger, established businesses. ● During difficult economic times, bank loans can virtually disappear. Different Forms of Short-Term Loans ● Secured loan — Backed by collateral. ● Unsecured loan — Doesn’t require any collateral. ● Line of credit — Given amount of unsecured short-term funds a bank will lend, provided the funds are readily available. ● Commercial finance companies are non-deposit-type organizations that make short-term loans to borrowers who offer tangible assets (property, plant, and equipment) as collateral. Factoring Accounts Receivable ● Factoring — The process of selling accounts receivable for cash. ● Factors (market intermediaries) 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. ● Since commercial paper is unsecured, only financially stable firms can sell it. Credit Cards ● An estimated one-third of all small firms use credit cards to finance their businesses. ● Credit cards are convenient but costly for a small business. Ways to Raise Start-Up Capital ● ● ● ● ● Join a crowdfunding site. Seek out microfinancing. Use asset-based lending or factoring. Sweet-talk vendors you want to do business with. Ask family and friends to invest. How Companies Fail to Raise Capital 1. There is no formalized business plan to show need or plan for returning on investment. 2. The company does not know how much to request from a lender. 3. The company has poor credit. 4. The company is either overvalued or undervalued. 5. Management is unrealistic about growth. Obtaining Long-Term Financing Long-term Financing Objectives ● 1. 2. 3. Financial managers generally ask three questions: What are the organization’s long-term goals and objectives? What funds do we need to achieve the firm’s long-term goals and objectives? What sources of long-term funding (capital) are available, and which will best fit our needs? Debt Financing Debt Financing by Borrowing from Lending Institutions: ● Long-term financing loans generally come due within 3 to 7 years but may extend to 15 or 20 years. ● Term-loan agreement — A promissory note that requires the borrower to repay the loan in specified installments. ● A major advantage is that loan interest is tax-deductible. ● Risk/return trade-off — The principle that the greater the risk a lender takes in making a loan, the higher the interest rate required. Debt Financing continued Debt Financing by Issuing Bonds: ● A bond is like an I O U with a promise to repay the amount borrowed, with interest, on a certain date. ● Secured bonds are issued with some form of collateral, such as real estate. ● Unsecured (debenture) bonds are backed only by the reputation of the issuer. Equity Financing Equity Financing by Selling Stock. Equity Financing from Retained Earnings. Equity Financing from Venture Capital. ● Venture capital — Money that is invested in new or emerging companies that are perceived as having great profit potential. Want to Attract a Venture Capitalist 1. 2. 3. 4. 5. 6. Can the company grow? Are you and your team problem solvers? Do you make good financial decisions? Have you done your research on us? Will we get our money back and more? Will it be worth our money and effort? Comparing Debt and Equity Financing Leverage — Raising needed funds through borrowing to increase the firm’s rate of return. ● Increases risk but enhances the firm’s ability to increase profits. Cost of capital — The rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders. Lessons Learned from the Financial Crisis and Great Recession ● The recent financial crisis was the worst fall since the Great Depression. ● Led to the passage of sweeping financial regulatory reform. ● Government is increasing involvement and intervention.