Pride/Hughes/Kapoor Business, 10th Edition

Audio Review Transcript
Chapter 19 Mastering Financial Management

1. Explain the need for financial management in business

Let’s start by looking at financial management and understanding why it is so important. Financial management consists of all the activities concerned with obtaining money and using it effectively. It involves careful planning and starts with determining the organization’s financial needs. The original investment by the owners is enough to get the business started. But income and expenses may vary from month to month and from year to year, leading to a need for temporary financing. Short-term financing is money that will be used in one year or one operating cycle, or less. Businesses typically need short-term financing due to cash flow, the movement of money into and out of an organization; speculative production, the time lag between the actual production of goods and when the goods are sold; or inventory issues. . Credit transactions that may not be paid for in 30 or 60 days can create a need for short-term financing. Likewise, manufacturers, wholesalers, and retailers make a significant investment in inventory, which can also create a need for short-term financing.
Long-term financing is money that will be used for longer than one year. It is frequently needed for business expansions and mergers, product development, marketing, and replacement of obsolete equipment.
Both short- and long-term financing require careful financial management, especially since poor financial management is one of the major reasons that businesses fail. Financial management can be viewed as a two-sided problem. On one side, the uses of funds often dictate the type or types of financing needed by a business. On the other side, the activities a business can undertake are determined by the types of financing available. Financial managers must ensure that funds are available when needed, that they are obtained at the lowest possible cost, that they are used as efficiently as possible, and that they are available for the repayment of debt.
. They must also consider the risk-return ratio, a ratio based on the principle that a high-risk decision should generate higher financial returns for a business and more conservative decisions often generate lesser returns. Proper financial management (1) establishes financing priorities that align with the organization’s goals and objectives, (2) plans and controls spending, (3) ensures sufficient financing is available when needed, and (4) invests excess cash. Finance clearly provides a variety of career opportunities in a wide range of industries. At the top is a chief financial officer (CFO), a high-level corporate executive who manages a firm’s finances and reports directly to the company’s chief executive officer or president. (LO 1 ends)

2. Summarize the process of planning for financial management

Let’s now look at the planning part of financial management. A financial plan is a plan for obtaining and using the money needed to implement an organization’s goals. It typically consists of three steps. The first step is establishing organizational goals and objectives. The second step is budgeting for financial needs. A budget is a financial statement that projects income and/or expenditures over a specified future period. Once a firm’s goals and objectives are set, planners can forecast the costs the firm will incur and the sales revenues it will receive. When the costs and revenues are combined, financial planners can determine whether they must seek additional funding from sources outside the firm. Budgeting usually starts with the budgets for sales and expenses of individual departments. Financial managers then combine each department’s budget into a company-wide cash budget. A cash budget estimates cash receipts and cash expenditures over a specified period. Most firms use one of two approaches to budgeting. In the traditional approach, each new budget is based on the dollar amounts contained in the budget for the preceding year, with adjustments as necessary. In zero-base budgeting, every expense in every budget must be justified every year. Departmental and cash budgets emphasize short-term financing needs. To develop a plan for long-term financing, managers often construct a capital budget, which estimates a firm’s expenditures for major assets including new product development, expansion of facilities, replacement of obsolete equipment, and mergers and acquisitions.
The third step in financial planning, after setting objectives and determining the budget, is identifying sources of funds. The four primary sources are sales revenue, equity capital, debt capital, and proceeds from the sales of assets. Sales revenue provides the greatest part of a firm’s financing. Equity capital is money received from the owners or from the sales of shares of ownership in the business. Debt capital is borrowed money obtained through loans either for short-term or long-term use. Proceeds from the sales of assets is a drastic step, but assets may be sold when they are no longer needed or no longer fit with the company’s core business or goals. Once the needed funds have been obtained, the financial manager is responsible for ensuring that they are used properly. This is achieved through a system of monitoring and evaluating the firm’s financial activities.  (LO 2 ends)

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

If a firm decides to use debt financing, it may use it either for short-term or long-term needs. Each has different methods, with associated advantages and disadvantages. Let’s start by looking at forms of unsecured short-term financing. Unsecured financing is not backed by collateral. Types of unsecured financing include trade credit, promissory notes, bank loans, and commercial paper. Trade credit is a type of short-term financing extended by a seller who does not require immediate payment after delivery of merchandise. It is usually granted by manufacturers and wholesalers to retailers, and allows them 30 to 60 days or more to pay. A promissory note is a written pledge by a borrower to pay a certain sum of money to a creditor at a specified future date. Promissory notes usually include an interest payment as well. It is a legally binding enforceable document that is also a negotiable instrument. Banks offer loans at various interest rates. The prime interest rate is the lowest rate charged by a bank for a short-term loan. It is reserved for companies with excellent credit ratings. Banks offer loans through promissory notes, lines of credit, or a revolving credit agreement, which is a guaranteed line of credit. Commercial paper is a short-term promissory note issued by a large corporation. It is issued in large denominations ranging from $5,000 to $100,000 and is secured only by the reputation of the issuing firm; no collateral is involved.     
Sometimes firms are required to seek secured loans. Almost any asset can serve as collateral, but inventories and receivables are the most common. When inventory is used as collateral, it must be stored at a public warehouse, and the receipt issued by the warehouse is retained by the lender until the debt is repaid. A special type of financing is called floor planning, in which title to merchandise is given to lenders in return for short-term financing. This method is commonly used by car, furniture, and appliance dealers. The other type of loan is secured by receivables. Accounts receivable are amounts owed to a firm by its customers. The borrower turns payments over to the lender as they are received or customers can make payments directly to the lender. Sometimes accounts receivable are factored to raise money. A factor is a firm that specializes in buying other firms’ accounts receivable. The factor buys the receivables at less than their face value, but collects the full dollar amount. Trade credit is the least expensive source of short-term financing.  (LO 3 ends)

4. Evaluate the advantages and disadvantages of equity financing

Now let’s turn to sources of equity financing. For corporations, sources include the sale of stock, the use of retained earnings, and venture capital. Advantages to selling stock include (1) the corporation doesn't have to repay money obtained from the sale of stock, and (2) it is under no legal obligation to pay dividends to stockholders. Of course, this is unlikely to please stockholders. When a corporation sells common stock to the general public for the first time, it is called an initial public offering, or IPO. Usually, the corporation uses an investment banking firm, an organization that assists corporations in raising funds, usually by helping sell new issues of stocks, bonds, or other financial securities. There are two types of stock: common and preferred. Common stock owners may vote on corporate matters, but their claims on profits and assets are subordinate to the claims of others. At the annual meeting common stockholders may vote for the board of directors and approve or disapprove of major corporate actions. Owners of preferred stock usually do not have voting rights, but their claims on dividends and assets are paid before those of common stockholders. The dividend on a share of preferred stock is known before the stock is purchased because it is stated on the stock certificate either as a percent of the par value or as a specified dollar amount. The par value is an assigned, and often arbitrary dollar value printed on the stock certificate. A corporation usually issues just one kind of common stock but may issue several types of preferred. If a firm believes it can issue a new preferred stock that pays a lower dividend, it may decide to buy shares on the market like any investor or exercise a call provision. Another provision firms sometimes offer is convertible preferred stock, which is preferred stock that an owner may exchange for a specified number of shares of common stock.
The second source of equity financing is its retained earnings, the portion of a business' profits not distributed to stockholders. The amount of retained earnings in any given year is determined by management and approved by the board of directors. Money that is retained is reinvested in the corporation, which tends to increase the value of the stock while providing virtually cost-free financing.
The third source of equity financing is venture capital, money invested in a firm that has the potential to become very successful. Most venture capital firms consist of a pool of investors, a partnership established by a wealthy family, or an insurance company. In return for financing, these investors receive an equity position in the business and share in its profits. Another method of raising capital is through a private placement, which occurs when stock and other corporate securities are sold directly to insurance companies, pension funds, or large institutional investors. (LO 4 ends)

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

Now let’s turn from equity financing to sources of long-term debt financing. Borrowing does not always indicate weakness in a corporation. Successful businesses often use the financial leverage that borrowed money creates to improve their financing performance. Financial leverage is the use of borrowed funds to increase the return on owners’ equity. This plan works as long as the firm’s earnings are larger than the interest charged for the borrowed money. If earnings are less than expected, however, the fixed interest charge actually reduces or eliminates return on equity.
If a firm cannot secure a long-term loan to acquire property, buildings, or equipment, it may choose to lease. A lease is an agreement by which the right to use real estate, equipment, or other assets is temporarily transferred from the owner to the user. The owner of the leased item is the lessor; the user is the lessee.
Long-term loans are available from commercial banks, insurance companies, pension funds, and other financial institutions. When the loan repayment period is longer than one year, the borrower must sign a term-loan agreement, which requires the borrower to repay the loan in monthly, quarterly, semiannual, or annual installments. Long-term business loans are typically repaid over 3 to 7 years. Although some long-term loans are unsecured, most require some form of collateral.
Another source of debt financing is corporate bonds. A corporate bond is a corporation’s written pledge that it will repay a specified amount of money with interest. The maturity date is the date on which the corporation is to repay the borrowed money. The corporation then pays interest to the bondholder, generally every 6 months, until maturity. Most corporate bonds are registered bonds, which means the bond is registered in the owner’s name by the issuing company.
A corporate bond is generally classified either as a debenture bond, which is backed only by the reputation of the issuing corporation; a mortgage bond, which is secured by various assets of the issuing firm; or a convertible bond, which can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock.
Maturity dates for bonds range from 10 to 30 years after the date of issue. If the interest is not paid or the firm becomes insolvent, bond owners’ claims on the assets of the corporation take precedence over both common and preferred stockholders. Some bonds have a callable feature, in which case the corporation usually pays the owner a call premium. The amount of the call premium is stated in the bond indenture, the legal document that details all the conditions relating to a bond issue. A corporation may use one of the three methods to ensure that it has sufficient funds available to redeem a bond issue. First, it can issue serial bonds, which are bonds of a single issue that mature on different dates. Second, the firm can establish a sinking fund, a sum of money to which deposits are made each year for the purpose of redeeming a bond issue. Third, a firm can pay off an old bond issue by selling new bonds.
A corporation that issues bonds must also appoint a trustee, an individual or an independent firm that acts as the bond owners’ representative. The corporation must report to the trustee periodically regarding its ability to make interest payments and redeem the bonds.
When comparing the cost of equity and debt long-term financing, the ongoing costs of using stock (equity) to finance a business are low. The most expensive is a long-term loan (debt).  (LO 5 ends)