Chapter 04

Financial
Management

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Management
LEARNING GOALS
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
2
Value of Understanding Finance

Three of most common reasons a firm fails are:

1. Undercapitalization (insufficient funds to start

business

2. Poor control over cash flow.

3. Inadequate expense control

3
WHAT IS FINANCE?

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

4
FINANCIAL MANAGEMENT

Financial Management --
The job of managing a firms
resources to meet its goals
and objectives.

18-5
THE ROLE OF FINANCE AND FINANCIAL MANAGERS

Financial Managers -- Examine financial data

prepared by accountants and recommend strategies
for improving financial performance

Financial managers are

responsible for:
- Paying company bills
- Collecting payments
- Staying informed of market
changes
- Assuring accounting
accuracy
6
WHOS WHO in FINANCE-Corp.
CFO -- Chief Financial Officer; VP of Finance
Comptroller -- Chief Accounting Officer
o Corporate Controller/CPA Accounting
activities: closing the books, FASB
interpretation - GAAP, interface with external
auditors, monthly, quarterly and annual
reporting
o Functional Controllers: budgets, forecasts,
provide financial support to functional heads:
Marketing, R&D, Production etc.
VP of Taxes Federal, state, local tax
Treasurer Financing activities; managing the
firms liquid assets, oversight of pension funds
7
TOP FINANCIAL CONCERNS
OF COMPANY CFOs - MACRO
Federal-government policies

Monthly, quarterly and annual

results

Credit markets/interest rates,

exchange issues

Revenues, cost of goods,

profits, projections reflection
of consumer demand

Source: CFO Magazine, July/August 2010.

8
 TOP FINANCIAL CONCERNS
of COMPANY CFOs - MICRO

Ability to maintain profit

margins

Ability to forecast quarterly,

annual and 5 year results

Benefit costs (healthcare &

pension)

Working-capital management

Acquisitions/Merger impacts
Source: CFO Magazine, July/August 2010.
9
FINANCIAL PLANNING

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 firms 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

10
FINANCIAL FORECASTING
Short-Term Forecast (Budget) -- Predicts revenues,
costs and expenses for a period of one year or less

o Cash-Flow Forecast -- Predicts the cash inflows

and outflows in future periods, usually months or
quarters based on above forecast

Long-Term Forecast (strategic plan) -- Predicts

revenues, costs, and expenses for as long as five or ten
years

Forecast to Forecast Variance Explanation Why

forecast changes from one reporting period to the next
Glo-Bus 11
BUDGETING

Budget -- Sets forth managements 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 primary guide for financial

operations and expected financial needs, usually
for the next year.

12
3 TYPES of BUDGETS in Financial Plan
Capital Budget -- Highlights a firms spending plans
for major asset purchases that often require large sums
of money & have useful life > 1 year & benefit > than
specified $ amount (varies by firm). E.g.: PPEs

Cash Budget -- Estimates cash inflows and

outflows during a particular period like a month or
quarter. Helps managers anticipate borrowing needs
and estimate debt repayments, operating expenses

Operating (Master) Budget -- Ties together all the

firms other budgets by area and summarizes its
proposed financial activities. Detailed costs and
expenses - supplies, rent, travel, technology, ads,
salaries etc. 13
FINANICAL PLANNING
Financial Plan: long-/ short-
term sales & profit forecasts

Budgets: allocate resources

based on forecasts; capital
(major investments), cash
(short-term), operating
(comprehensive)

Financial Control: compares

actual to budget performance;
also forecast to forecast
changes

14
ESTABLISHING FINANCIAL CONTROL

Financial Control -- A process

in which a firm periodically
compares its actual revenues,
costs and expenses with its
budget.

Usually done monthly

18-15
 FACTORS USED IN ASSESSING
FINANCIAL CONTROL

Is the firm meeting its short-term financial commitments?

Is the firm reviewing its inventory levels on a monthly basis?

Is the firm producing adequate operating profits on its

assets?

How is the firm financing its assets? (Cash, Loans, Equity?)

Are the firms owners receiving an acceptable return on their

investment (ROI)?

What is the process for reviewing capital expenditures?

16
 17

Quick Quiz
1. Financial managers use data prepared by accountants to
develop strategies for improving the financial performance of
the firm
a) True b) False

2. Financial management is more important for a large firm than

it is for a small firm.
a) True b) False

3. Which of the following represents a capital expenditure?

A. issuing paychecks to workers
B. paying for advertising on a local radio station
C. purchasing raw materials to be used in the production of
a firm's product
D. purchasing a building to be used for office space
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

18
FUNDING SOURCES

Debt Financing -- The funds

raised through various forms of
borrowing that must be repaid.
Usually for short term financing.

Equity Financing -- The funds

raised from within the firm from
operations or through the sale of
ownership in the firm (such as
stock). Funds needed for more than
a year.

19
SHORT and LONG-TERM FINANCING

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

Long-Term Financing --
Funds needed for more than
a year. 5, 10 or even 20
years

18-20
TYPES of SHORT-TERM FINANCING

Trade Credit -- The practice of buying goods or

services now and paying for them later.

Common terms are 2/10 net 30 when receiving trade credit

(2% discount if paid within 10 days)

Promissory Note -- A written contract agreeing to pay

a supplier a specific sum of money at a definite time.
Used when supplier thinks organization has poor credit
history.

21
TYPES of SHORT-TERM FINANCING

Many small businesses obtain short-term

financing from friends and family.

If asking for help from family or friends, its

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

22
DIFFERENT FORMS OF SHORT-TERM LOANS

- Secured Loans -- Backed by collateral (e.g.

receivables, or other liquid asset)
- Automobile loan is secured loan
- Unsecured Loans -- Dont require collateral from the
borrower (only given to highly regarded customer.)
- 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 thats
guaranteed but comes with a fee
- Commercial Finance Companies companies cant
get funds elsewhereTangible assets as collateral,
with higher interest. GE
23
 DIFFICULTY of OBTAINING SHORT-TERM
FINANCING

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

The recent financial crisis has made it difficult for

even promising and well-organized businesses to
get loans.

24
FACTORING
Factoring -- The process of
selling accounts receivable
for cash. (e.g. collection
agency)

A factor is a market
intermediary (usually a
financial institution or a
commercial bank) that
agrees to buy the firms AR,
at a discount. Factors charge more
than banks, but many
Expensive source of short
small businesses dont
term funds
qualify for loans.
25
COMMERCIAL PAPER

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.

Quick path to short term funds at lower rate than

charged by banks

Lenders are often investors

26
EXPLORING the FINANCING UNIVERSE
(Spotlight on Small Business)
New Market Entrants
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 auto-matches business owners with the right
type of business loan and lender.

o Lendio also offers services such as a business

plan makeover and website design for a fee.

o Others - Spotloans, eloans, Lending tree,

Quicken loans etc. 18-27
Credit Cards
Readily available line of credit

Per National Small Business Association

(NSBA) almost half of small firms use
credit cards to finance businesses

Small business credit cards not covered

by Credit Card Act passed in 2009, rates
have increased almost 30%

Credit Cards are best used as a last resort

both by small businesses and consumers,
as they have costly terms
28
LONG-TERM FINANCING OBJECTIVES
In setting long term financing objectives,
finance managers ask 3 questions:

1. What are the long term goals & objectives of the

firm? Continue spend on R&D, build a new
production facility with state of the art equipment,
improve the General Offices, launch a new
product?
2. What funds do we need to achieve #1?

3. What sources of long-term funding are available

and which will best fit our needs?
29
Obtaining
Long-Term
Financing The FIVE Cs of CREDIT

1. The character of the borrower.

2. The borrowers capacity to repay the loan.

3. The capital being invested in the business by

the borrower.

4. The conditions of the economy and the firms

industry.

5. The collateral the borrower has available to

secure the loan.
18-30
USING LONG-TERM DEBT FINANCING

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 is tax deductible by the firm.

31
USING DEBT FINANCING by ISSUING BONDS
Similar to an IOU agreement with a
promise to repay with interest on a
certain date

Indenture Terms -- The terms of

agreement in a bond issue.

Secured Bond -- A bond or loan

issued with some form of collateral
(i.e. real estate, equipment, etc.)

Unsecured (Debenture) Bond -- A

bond backed only by the reputation of
the issuing company. 32
SECURING EQUITY FINANCING

A company can secure equity financing by:

- 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.

33
DIFFERENCES BETWEEN DEBT and EQUITY
FINANCING
Types of Financing

Conditions Debt Equity

None. Unless special Common stock
Management
conditions have been holders have voting
influence
agreed on rights
Debt has a maturity Stock has no maturity
Repayment
date date

Firm is not legally

Yearly obligations Interest payments
liable to pay dividends

Interest is tax Dividends are not tax

Tax benefits
deductible deductible

34
USING LEVERAGE for FUNDING NEEDS

Leverage -- Raising funds through borrowing to

increase the firms rate of return.

Debt enhances a firms ability to increase profits

Firms need to always assess the 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.

35
LESSONS of the FINANCIAL CRISIS

The recent financial crisis was the worst fall since

the Great Depression.
Led to the passage of
sweeping financial reform.
Government is increasing
involvement and
intervention. Interventions
benefited large corporations
from collapsing and
increases stringency in the
financial sector. 36
 37

Quick Quiz
1. The first step in financial planning is to develop a budget
to better control costs

a) True b) False

2. A major concern for firms selling on credit is:

a) the realization that many credit customers always pay
their bills.
b) the large amount of assets tied up in accounts
receivable.
c) the resulting increase in the debt ratio for the firm.
d) the inability to utilize factoring as a source of financing.
Assessment

ASSESSMENT
What are the two major forms of long term debt
financing available to a firm?
Term loan agreement and Issuing Bonds

How does debt financing differ from equity financing?

Management influence: debt no, equity yes; Debt : maturity
date, equity(stock) has none; Debt: interest payments, annual
dividends not required for equity; Debt interest tax deductible,
Dividends are not.

Three major forms of equity financing available to a

firm?
Stock issuance, retained earnings, venture capital
38
 39

Class Activity
Go online and check the capitalization required to open a
franchise of your choice, like Subway, KFC or McDonalds.
Does the franchisor offer financial assistance to
prospective franchisees? Evaluate the cost of the
franchise versus its business potential in your
neighborhood.