Chapter 20 Mastering Financial Management


Nov 10, 2013 (3 years and 7 months ago)





Audio Review Transcript


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
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 t
o 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.
term financing

is money
that will be used in one year or one operating cycle, or less. Businesses typic
ally need
term financing due to
cash flow
, the movement of money into and out of an
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.

term financing

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
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

side, the activities a business can undertake are determined by the types of financing
Financial managers must ensure that funds are available when needed, that they
are obtained at the lowest possible cost,
that they are used as effi
ciently as possible
, and
that they are available for the repayment of debt.


. They must also consider the
return ratio
, a ratio based on the principle that a
risk decision should generate higher financial returns for a business and more
tive 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 need
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
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 neede
d to implement an organization’s goals. It
typically consists of three steps. The

step is establishing organizational goals and
objectives. The

step is budgeting for financial needs. A

is a financial
statement that projects income and/o
r 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 determin
e 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
wide cash budget.

cash budget

estimates cash receipts and cash expenditures
over a specified period. Most firms use one of two approaches to budgeting. In the

approach, each new budget is based on the dollar amounts contained in the
budget for the preceding y
ear, with adjustments as necessary. In
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
financing, managers often construct
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.



step in financial planning, after setting object
ives 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 capita

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

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

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

If a firm decides to use debt financing, it may use it either for short
term or long
erm needs. Each has different methods, with associated advantages and disadvantages.
Let’s start by looking at forms of unsecured short
term financing.
Unsecured financing

not backed by collateral. Types of unsecured financing include trade credit, prom
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, a
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
nforceable document that is also a negotiable instrument.

offer loans at various
interest rates. The
prime interest rate

is the lowest rate charged by a bank for a short
loan. It is reserved for companies with excellent credit ratings. Banks off
er loans through
promissory notes, lines of credit, or a
revolving credit agreement
, which is a

line of credit.
Commercial paper

is a short
term promissory note issued by a large


corporation. It is issued in large denominations ranging from $5,0
00 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 in
ventory 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
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 pay
ments 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

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

(LO 3 ends)

4. Evaluate the advantages and disadvantages of equity financing

Now let’s turn to source
s 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 i
s 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
. 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

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 o

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 seve
ral 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 prefe
rred 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 financin

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
, which occurs when stock and other corporate securities are sold direct
ly to
insurance companies, pension funds, or large institutional investors.

(LO 4 ends)

5. Evaluate the advantages and disadvantages o
f long
term debt financing

Now let’s turn from equity financing to sources of long
term debt financing.
Borrowing does n
ot always indicate weakness in a corporation. Successful businesses
often use the financial leverage that borrowed money creates to improve their financing
Financial leverage

is the use of borrowed funds to increase the return on
owners’ equit
y. 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

term loan to acquire property, buildings, or
equipment, it may choose to lease. A

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 i
tem is the
; the user is the

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

, which requires the
borrower to repay the loan in monthly, quarterly, semiannual, or annual installments.
term business loans are typically repaid over 3 to 7 years. Although some long
loans are unsecured, most require some form of col

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.
maturity date

is the date on which the corporation is to repay the borrowed m
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 cl
assified 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 spe
cified 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 prec
edence 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
, it can issue
serial bonds
, which are bonds of a single issue that mature on
different d
, 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.
, a firm can
pay off an old bond issue by
selling new bonds

A corporation that issues bonds must also
appoint a
, 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 e
quity 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)