Chapter Twelve

Mastering Financial Management

SPL 1302 Basic Commerce Dr. M. Khata Jabor Department of Technical and Engineering Education Faculty of Education

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Learning Objectives

1. Explain the need for financing and financial 2.

management in business. Summarize the process of planning for financial management Describe the advantages and disadvantages of different methods of short-term debt financing. Evaluate the advantages and disadvantages of equity financing. Evaluate the advantages and disadvantages of long-term debt financing.
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3.
4. 5.

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 organizations goals Planning

The need for financing

When expenses are high or sales are low Opportunities to expand
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The Need for Financing

Short-term financing
Money that will be used for one year or less
Cash flowthe movement of money into and out of an organization Inventoryspeculative 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
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Cash Flow for a Manufacturing Business

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Comparison of Short- and Long-Term Financing

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The Need for Financial Management

Risk-return 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 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 Credit customers pay on time and delinquencies are reduced Bills are paid promptly Taxes are paid in a timely manner Excess cash is invested in interest-bearing securities

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Careers in Finance
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
Bank officer Credit officer Financial analyst Financial planner Insurance analyst Investment account executive
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Jobs

PlanningThe Basis of Sound Financial Management

Financial plan
A plan for obtaining and using the money needed to implement an organizations goals

Developing the financial plan

Establishing organizational goals and objectives Budgeting for financial needs Identifying sources of funds

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The Three Steps of Financial Planning

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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

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Developing the Financial Plan (contd)

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 firms expenditures for major assets and its long-term financing needs

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Sales Budget for Stars and Stripes Clothing

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Cash Budget for Stars and Stripes Clothing

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Developing the Financial Plan (contd)

Identifying sources of funds
Sales revenues
Provide the greatest part of the firms 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

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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

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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

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Sources of Unsecured Short-Term Debt Financing (contd)

Unsecured bank loans
Interest rates vary with each borrowers 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 shortterm loans

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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 shortterm 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
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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 factors 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

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Comparison of Short-Term Financing Methods

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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

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Sources of Equity Financing (contd)

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
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Sources of Equity Financing (contd)

Selling stock (contd)
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 commonstock 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

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Sources of Equity Financing (contd)

Retained earnings
The portion of a corporations 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

Private Placement
Stocks and other corporate securities are sold directly to insurance companies, pension funds, or large institutional investors

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Sources of Long-Term Debt Financing

Financial leverage
The use of borrowed funds to increase the return on owners equity As long as the firms 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

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Effects of Additional Capital

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Sources of Long-Term Debt Financing (contd)

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 firms 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

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Sources of Long-Term Debt Financing (contd)

Corporate bonds
A corporations written pledge that it will repay a specified amount of money with interest Maturity datethe date on which the corporation is to repay the borrowed money Interest is paid until maturity Types of bonds
Registered bonda bond registered in the owners name by the issuing company Debenture bonda bond backed only by the reputation of the issuing corporation Mortgage bonda bond secured by various assets of the issuing firm Convertible bonda bond that can be exchanged, at the owners option, for a specified number of shares of the corporations common stock

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Sources of Long-Term Debt Financing (contd)

Corporate bonds (contd)

Repayment provisions for corporate bonds
Bond indenturea legal document that details all the conditions relating to a bond issue Call premiuman amount paid to the bond owner if the corporation buys back the bond before the maturity date Serial bondsbonds of a single issue that mature on different dates Sinking funda sum of money to which deposits are made each year for the purpose of redeeming a bond issue Trusteean individual or an independent firm that acts as the bond owners representative
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Comparison of Long-Term Financing Methods

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