Pride/Hughes/Kapoor Business, 109th Edition

Audio Review Transcript

Chapter1920MasteringFinancialManagement
1.Explaintheneedforfinancialmanagementinbusiness
Letsstartbylookingatfinancialmanagementandunderstandingwhyitisso
important.Financialmanagementconsistsofalltheactivitiesconcernedwithobtaining
moneyandusingiteffectively.Itinvolvescarefulplanningandstartswithdetermining
theorganizationsfinancialneeds.Theoriginalinvestmentbytheownersisenoughtoget
thebusinessstarted.Butincomeandexpensesmayvaryfrommonthtomonthandfrom
yeartoyear,leadingtoaneedfortemporaryfinancing.Shorttermfinancingismoney
thatwillbeusedinoneyearoroneoperatingcycle,orless.Businessestypicallyneed
shorttermfinancingduetocashflow,themovementofmoneyintoandoutofan
organization;speculativeproduction,thetimelagbetweentheactualproductionofgoods
andwhenthegoodsaresold;orinventoryissues..Credittransactionsthatmaynotbe
paidforin30or60dayscancreateaneedforshorttermfinancing.Likewise,
manufacturers,wholesalers,andretailersmakeasignificantinvestmentininventory,
whichcanalsocreateaneedforshorttermfinancing.
Longtermfinancingismoneythatwillbeusedforlongerthanoneyear.Itis
frequentlyneededforbusinessexpansionsandmergers,productdevelopment,marketing,
andreplacementofobsoleteequipment.
Bothshortandlongtermfinancingrequirecarefulfinancialmanagement,
especiallysincepoorfinancialmanagementisoneofthemajorreasonsthatbusinesses
fail.Financialmanagementcanbeviewedasatwosidedproblem.Ononeside,theuses
offundsoftendictatethetypeortypesoffinancingneededbyabusiness.Ontheother
side,theactivitiesabusinesscanundertakearedeterminedbythetypesoffinancing
available.Financialmanagersmustensurethatfundsareavailablewhenneeded,thatthey

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areobtainedatthelowestpossiblecost,andthattheyareusedasefficientlyaspossible,
andthattheyareavailablefortherepaymentofdebt.
.Theymustalsoconsidertheriskreturnratio,aratiobasedontheprinciplethata
highriskdecisionshouldgeneratehigherfinancialreturnsforabusinessandmore
conservativedecisionsoftengeneratelesserreturns.Properfinancialmanagement(1)
establishesfinancingprioritiesthatalignwiththeorganizationsgoalsandobjectives,(2)
plansandcontrolsspending,(3)ensuressufficientfinancingisavailablewhenneeded,
and(4)investsexcesscash.Financeclearlyprovidesavarietyofcareeropportunitiesina
widerangeofindustries.Atthetopisachieffinancialofficer(CFO),ahighlevel
corporateexecutivewhomanagesafirmsfinancesandreportsdirectlytothecompanys
chiefexecutiveofficerorpresident.(LO1ends)
2.Summarizetheprocessofplanningforfinancialmanagement
Letsnowlookattheplanningpartoffinancialmanagement.Afinancialplanisa
planforobtainingandusingthemoneyneededtoimplementanorganizationsgoals.It
typicallyconsistsofthreesteps.Thefirststepisestablishingorganizationalgoalsand
objectives.Thesecondstepisbudgetingforfinancialneeds.Abudgetisafinancial
statementthatprojectsincomeand/orexpendituresoveraspecifiedfutureperiod.Oncea
firmsgoalsandobjectivesareset,plannerscanforecastthecoststhefirmwillincurand
thesalesrevenuesitwillreceive.Whenthecostsandrevenuesarecombined,financial
plannerscandeterminewhethertheymustseekadditionalfundingfromsourcesoutside
thefirm.Budgetingusuallystartswiththebudgetsforsalesandexpensesofindividual
departments.Financialmanagersthencombineeachdepartmentsbudgetintoa
companywidecashbudget.Acashbudgetestimatescashreceiptsandcashexpenditures
overaspecifiedperiod.Mostfirmsuseoneoftwoapproachestobudgeting.Inthe
traditionalapproach,eachnewbudgetisbasedonthedollaramountscontainedinthe
budgetfortheprecedingyear,withadjustmentsasnecessary.Inzerobasebudgeting,
everyexpenseineverybudgetmustbejustifiedeveryyear.Departmentalandcash
budgetsemphasizeshorttermfinancingneeds.Todevelopaplanforlongterm
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financing,managersoftenconstructacapitalbudget,whichestimatesafirms
expendituresformajorassetsincludingnewproductdevelopment,expansionoffacilities,
replacementofobsoleteequipment,andmergersandacquisitions.
Thethirdstepinfinancialplanning,aftersettingobjectivesanddeterminingthebudget,
isidentifyingsourcesoffunds.Thefourprimarysourcesaresalesrevenue,equitycapital,
debtcapital,andproceedsfromthesalesofassets.Salesrevenueprovidesthegreatest
partofafirmsfinancing.Equitycapitalismoneyreceivedfromtheownersorfromthe
salesofsharesofownershipinthebusiness.Debtcapitalisborrowedmoneyobtained
throughloanseitherforshorttermorlongtermuse.Proceedsfromthesalesofassetsis
adrasticstep,butassetsmaybesoldwhentheyarenolongerneededornolongerfitwith
thecompanyscorebusinessorgoals.Oncetheneededfundshavebeenobtained,the
financialmanagerisresponsibleforensuringthattheyareusedproperly.Thisisachieved
throughasystemofmonitoringandevaluatingthefirmsfinancialactivities.(LO2
ends)
3.Describetheadvantagesanddisadvantagesofdifferentmethodsofshorttermdebt
financing
Ifafirmdecidestousedebtfinancing,itmayuseiteitherforshorttermorlong
termneeds.Eachhasdifferentmethods,withassociatedadvantagesanddisadvantages.
Letsstartbylookingatformsofunsecuredshorttermfinancing.Unsecuredfinancingis
notbackedbycollateral.Typesofunsecuredfinancingincludetradecredit,promissory
notes,bankloans,andcommercialpaper.Tradecreditisatypeofshorttermfinancing
extendedbyasellerwhodoesnotrequireimmediatepaymentafterdeliveryof
merchandise.Itisusuallygrantedbymanufacturersandwholesalerstoretailers,and
allowsthem30to60daysormoretopay.Apromissorynoteisawrittenpledgebya
borrowertopayacertainsumofmoneytoacreditorataspecifiedfuturedate.
Promissorynotesusuallyincludeaninterestpaymentaswell.Itisalegallybinding
enforceabledocumentthatisalsoanegotiableinstrument.Banksofferloansatvarious
interestrates.Theprimeinterestrateisthelowestratechargedbyabankforashortterm
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loan.Itisreservedforcompanieswithexcellentcreditratings.Banksofferloansthrough
promissorynotes,linesofcredit,orarevolvingcreditagreement,whichisaguaranteed
lineofcredit.Commercialpaperisashorttermpromissorynoteissuedbyalarge
corporation.Itisissuedinlargedenominationsrangingfrom$5,000to$100,000andis
securedonlybythereputationoftheissuingfirm;nocollateralisinvolved.
Sometimesfirmsarerequiredtoseeksecuredloans.Almostanyassetcanserveas
collateral,butinventoriesandreceivablesarethemostcommon.Wheninventoryisused
ascollateral,itmustbestoredatapublicwarehouse,andthereceiptissuedbythe
warehouseisretainedbythelenderuntilthedebtisrepaid.Aspecialtypeoffinancingis
calledfloorplanning,inwhichtitletomerchandiseisgiventolendersinreturnforshort
termfinancing.Thismethodiscommonlyusedbycar,furniture,andappliancedealers.
Theothertypeofloanissecuredbyreceivables.Accountsreceivableareamountsowed
toafirmbyitscustomers.Theborrowerturnspaymentsovertothelenderastheyare
receivedorcustomerscanmakepaymentsdirectlytothelender.Sometimesaccounts
receivablearefactoredtoraisemoney.Afactorisafirmthatspecializesinbuyingother
firmsaccountsreceivable.Thefactorbuysthereceivablesatlessthantheirfacevalue,
butcollectsthefulldollaramount.Tradecreditistheleastexpensivesourceofshortterm
financing.(LO3ends)
4.Evaluatetheadvantagesanddisadvantagesofequityfinancing
Nowletsturntosourcesofequityfinancing.Forcorporations,sourcesinclude
thesaleofstock,theuseofretainedearnings,andventurecapital.Advantagestoselling
stockinclude(1)thecorporationdoesn'thavetorepaymoneyobtainedfromthesaleof
stock,and(2)itisundernolegalobligationtopaydividendstostockholders.Ofcourse,
thisisunlikelytopleasestockholders.Whenacorporationsellscommonstocktothe
generalpublicforthefirsttime,itiscalledaninitialpublicoffering,orIPO.Usually,the
corporationusesaninvestmentbankingfirm,anorganizationthatassistscorporationsin
raisingfunds,usuallybyhelpingsellnewissuesofstocks,bonds,orotherfinancial
securities.Therearetwotypesofstock:commonandpreferred.Commonstockowners
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mayvoteoncorporatematters,buttheirclaimsonprofitsandassetsaresubordinateto
theclaimsofothers.Attheannualmeetingcommonstockholdersmayvotefortheboard
ofdirectorsandapproveordisapproveofmajorcorporateactions.Ownersofpreferred
stockusuallydonothavevotingrights,buttheirclaimsondividendsandassetsarepaid
beforethoseofcommonstockholders.Thedividendonashareofpreferredstockis
knownbeforethestockispurchasedbecauseitisstatedonthestockcertificateeitherasa
percentoftheparvalueorasaspecifieddollaramount.Theparvalueisanassigned,and
oftenarbitrarydollarvalueprintedonthestockcertificate.Acorporationusuallyissues
justonekindofcommonstockbutmayissueseveraltypesofpreferred.Ifafirmbelieves
itcanissueanewpreferredstockthatpaysalowerdividend,itmaydecidetobuyshares
onthemarketlikeanyinvestororexerciseacallprovision.Anotherprovisionfirms
sometimesofferisconvertiblepreferredstock,whichispreferredstockthatanowner
mayexchangeforaspecifiednumberofsharesofcommonstock.
Thesecondsourceofequityfinancingisitsretainedearnings,theportionofa
business'profitsnotdistributedtostockholders.Theamountofretainedearningsinany
givenyearisdeterminedbymanagementandapprovedbytheboardofdirectors.Money
thatisretainedisreinvestedinthecorporation,whichtendstoincreasethevalueofthe
stockwhileprovidingvirtuallycostfreefinancing.
Thethirdsourceofequityfinancingisventurecapital,moneyinvestedinafirm
thathasthepotentialtobecomeverysuccessful.Mostventurecapitalfirmsconsistofa
poolofinvestors,apartnershipestablishedbyawealthyfamily,oraninsurance
company.Inreturnforfinancing,theseinvestorsreceiveanequitypositioninthe
businessandshareinitsprofits.Anothermethodofraisingcapitalisthroughaprivate
placement,whichoccurswhenstockandothercorporatesecuritiesaresolddirectlyto
insurancecompanies,pensionfunds,orlargeinstitutionalinvestors.(LO4ends)
5.Evaluatetheadvantagesanddisadvantagesoflongtermdebtfinancing
Nowletsturnfromequityfinancingtosourcesoflongtermdebtfinancing.
Borrowingdoesnotalwaysindicateweaknessinacorporation.Successfulbusinesses
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oftenusethefinancialleveragethatborrowedmoneycreatestoimprovetheirfinancing
performance.Financialleverageistheuseofborrowedfundstoincreasethereturnon
ownersequity.Thisplanworksaslongasthefirmsearningsarelargerthantheinterest
chargedfortheborrowedmoney.Ifearningsarelessthanexpected,however,thefixed
interestchargeactuallyreducesoreliminatesreturnonequity.
Ifafirmcannotsecurealongtermloantoacquireproperty,buildings,or
equipment,itmaychoosetolease.Aleaseisanagreementbywhichtherighttousereal
estate,equipment,orotherassetsistemporarilytransferredfromtheownertotheuser.
Theowneroftheleaseditemisthelessor;theuseristhelessee.
Longtermloansareavailablefromcommercialbanks,insurancecompanies,
pensionfunds,andotherfinancialinstitutions.Whentheloanrepaymentperiodislonger
thanoneyear,theborrowermustsignatermloanagreement,whichrequiresthe
borrowertorepaytheloaninmonthly,quarterly,semiannual,orannualinstallments.
Longtermbusinessloansaretypicallyrepaidover3to7years.Althoughsomelongterm
loansareunsecured,mostrequiresomeformofcollateral.
Anothersourceofdebtfinancingiscorporatebonds.Acorporatebondisa
corporationswrittenpledgethatitwillrepayaspecifiedamountofmoneywithinterest.
Thematuritydateisthedateonwhichthecorporationistorepaytheborrowedmoney.
Thecorporationthenpaysinteresttothebondholder,generallyevery6months,until
maturity.Mostcorporatebondsareregisteredbonds,whichmeansthebondisregistered
intheownersnamebytheissuingcompany.
Acorporatebondisgenerallyclassifiedeitherasadebenturebond,whichis
backedonlybythereputationoftheissuingcorporation;amortgagebond,whichis
securedbyvariousassetsoftheissuingfirm;oraconvertiblebond,whichcanbe
exchanged,attheownersoption,foraspecifiednumberofsharesofthecorporations
commonstock.
Maturitydatesforbondsrangefrom10to30yearsafterthedateofissue.Ifthe
interestisnotpaidorthefirmbecomesinsolvent,bondownersclaimsontheassetsof
thecorporationtakeprecedenceoverbothcommonandpreferredstockholders.Some
bondshaveacallablefeature,inwhichcasethecorporationusuallypaystheowneracall
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premium.Theamountofthecallpremiumisstatedinthebondindenture,thelegal
documentthatdetailsalltheconditionsrelatingtoabondissue.Acorporationmayuse
oneofthethreemethodstoensurethatithassufficientfundsavailabletoredeemabond
issue.First,itcanissueserialbonds,whicharebondsofasingleissuethatmatureon
differentdates.Second,thefirmcanestablishasinkingfund,asumofmoneytowhich
depositsaremadeeachyearforthepurposeofredeemingabondissue.Third,afirmcan
payoffanoldbondissuebysellingnewbonds.
Acorporationthatissuesbondsmustalsoappointatrustee,anindividualoran
independentfirmthatactsasthebondownersrepresentative.Thecorporationmust
reporttothetrusteeperiodicallyregardingitsabilitytomakeinterestpaymentsand
redeemthebonds.
Whencomparingthecostofequityanddebtlongtermfinancing,theongoing
costsofusingstock(equity)tofinanceabusinessarelow.Themostexpensiveisalong
termloan(debt).(LO5ends)

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