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 GOALSChapter Eighteen

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• Tomé worked her way up to Chief Financial Officer (CFO) at Home Depot in 2001.

CAROL TOMÉHome Depot

Profile

• Home Depot was in a store building frenzy; adding more than 100 locations a year through 2005.

• Tomé was at the center of tech transition by overseeing the distribution of $350 million in spending.

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NAME that COMPANYChapter Eighteen

At one time this company was the largest automobile maker in the world. Due to severe financial problems in 2009, the company came very close to extinction. A $7 billion government-backed loan and an additional $43 billion government investment in the company helped it survive. It is now attempting a comeback as a much smaller company.

Name that company!

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• 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

WHAT’S FINANCE?The Role of Finance and Financial Managers

LG1

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• Financial Management -- The job of managing a firm’s resources to meet its goals and objectives.

FINANCIAL MANAGEMENTLG1

The Role of Finance and Financial Managers

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• Financial Managers -- Examine financial data and recommend strategies for improving financial performance.

FINANCIAL MANAGERSLG1

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

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• CFO -- Chief Financial Officer

• CFP -- Certified Financial Planner

• CFA -- Chartered Financial Analyst

• Comptroller -- Chief Accounting Officer

WHO’S WHO in FINANCELG2

Financial Planning

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WHAT FINANCIAL MANAGERS DOLG1

The Role of Finance and Financial Managers

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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 regulationsSource: CFO Magazine, www.cfo.com, accessed July 2011.

LG1

The Role of Finance and Financial Managers

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1) Undercapitalization

2) Poor control over cash flow

3) Inadequate expense control

WHY DO FIRMS FAIL FINANCIALLY?

The Value of Understanding Finance

LG1

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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 2010.

LG1

The Value of Understanding Finance

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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 2010.

LG1

The Value of Understanding Finance

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• 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 PLANNINGFinancial Planning

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• 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 FORECASTINGForecasting Financial Needs

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• 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.

BUDGETINGWorking with the Budget Process

LG2

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• 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 BUDGETSLG2

Working with the Budget Process

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FINANICAL PLANNINGLG2

Working with the Budget Process

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• 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

LG2

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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

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• Name three finance functions important to the firm’s overall operations and performance.

• What three primary financial problems cause firms to fail?

• How do short-term and long-term financial forecasts differ?

• What’s the purpose of preparing budgets? Can you identify three different types of budgets?

PROGRESS ASSESSMENTProgress Assessment

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• 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

LG3

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• In Michigan, half of the state’s communities are in financial distress.

• Local Government and School District Fiscal Accountability Act allows cities, towns, and school districts to be taken over by state-appointed emergency financial managers (EFMs) selected by the Governor.

• Indiana is considering similar legislation. New York and other states’ boards have been given similar power.

FINANCIAL ORDER or FINANCIAL MARTIAL LAW?

(Legal Briefcase)

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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.

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The Need for Operating Funds

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• 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)

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• 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).

USING ALTERNATIVE SOURCES of FUNDS

Alternative Sources of Funds

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• Short-Term Financing -- Funds needed for a year or less.

• Long-Term Financing -- Funds needed for more than a year.

SHORT and LONG-TERM FINANCINGLG3

Alternative Sources of Funds

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WHY FIRMS NEED FINANCING

Short-Term Funds Long-Term Funds

Monthly expenses New-product development

Unanticipated emergencies Replacement of capital equipment

Cash flow problems Mergers or acquisitions

Expansion of current inventory Expansion into new markets

Temporary promotional programs New facilities

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Alternative Sources of Funds

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• Money has time value. What does this mean?

• Why is accounts receivable a financial concern of the firm?

• What’s the primary reason an organization spends a good deal of its available funds on inventory and capital expenditures?

• What’s the difference between debt and equity financing?

PROGRESS ASSESSMENTProgress Assessment

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• 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

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• 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

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• Banks generally prefer to lend short-term money to larger, more established businesses.

DIFFICULTY of OBTAININGSHORT-TERM FINANCING

Commercial Banks

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• The recent financial crisis has made it difficult for even promising and well-organized businesses to get loans.

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• Peer-to-peer lending sites like Lending Club match small businesses with lenders and receive a fee for their services.

• Lendio claims to have developed a technology that matches business owners with the right type of business loan and lender.

• Lendio also offers services such as a business plan makeover and website design for a fee.

EXPLORING the FINANCING UNIVERSE

(Spotlight on Small Business)

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• 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 LOANSLG4

Different Forms of Short-Term Loans

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• Factoring -- The process of selling accounts receivable for cash.

• Factors charge more than banks, but many small businesses don’t qualify for loans.

FACTORINGLG4

Factoring Accounts Receivable

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• 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 are able to sell it.

COMMERCIAL PAPERCommercial Paper

LG4

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• 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 CARDSCredit Cards

LG4

Photo Courtesy of: Robert Scoble

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WAYS to RAISE START-UP CAPITAL

• Seek out a microloan from a microlender

• Use asset-based lending or factoring

Source: Entrepreneur, www.entrepreneur.com, accessed July 2011.

• Turn to the web and seek out peer-to-peer lending

• Research local banks

• Sweet-talk vendors you want to do business with

LG4

Credit Cards

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• What does an invoice containing the terms 2/10, net 30 mean?

• What’s the difference between trade credit and a line of credit?

• What’s the key difference between a secured and an unsecured loan?

• What’s factoring? What are some of the considerations factors consider in establishing their discount rate?

PROGRESS ASSESSMENTProgress Assessment

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• 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

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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 CREDITLG5

Obtaining Long-Term Financing

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• 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

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• 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 BONDSLG5

Debt Financing

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• A company can secure equity financing by:

SECURING EQUITY FINANCINGEquity 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.

LG5

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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 2011.18-45

DIFFERENCES BETWEEN DEBT and EQUITY FINANCING

Comparing Debt and Equity Financing

Types of Financing

Conditions Debt Equity

Management influenceNone. Unless special conditions have been agreed on.

Common stock holders have voting rights.

RepaymentDebt has a maturity date.

Stock has no maturity date.

Yearly obligations Payment of interest.The firm isn’t legally liable to pay dividends.

Tax benefitsInterest is tax deductible.

Dividends are not tax deductible.

LG5

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• 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 NEEDSLG5

Comparing Debt and Equity Financing

18-47

• The recent financial crisis was the worst fall since the Great Depression.

LESSONS of the FINANCIAL CRISISLG5

Lessons From the Financial Crisis

• Led to the passage of sweeping financial reform.

• Government is increasing involvement and intervention.

18-48

• What are the two major forms of debt financing available to a firm?

• How does debt financing differ from equity financing?

• What are the three major forms of equity financing available to a firm?

• What is leverage, and why do firms choose to use it?

PROGRESS ASSESSMENTProgress Assessment

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