chapter 15 and chapter 16

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Chapter 16

Mastering Financial Management

Pride/Hughes/Kapoor, Foundations of Business, 6th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Objectives

16-1 Understand why financial management is important in today’s competitive economy.

16-2 Identify a firm’s short- and long-term financial needs.

16-3 Summarize the process of planning for financial management.

16-4 Identify the services provided by banks and financial institutions for their business customers.

16-5 Describe the advantages and disadvantages of different methods of short-term debt financing.

16-6 Evaluate the advantages and disadvantages of equity financing.

16-7 Evaluate the advantages and disadvantages of long-term debt financing.

The Need for Financial Management

Financial management – all the activities concerned with obtaining money and using it effectively

Proper financial management must ensure that:

Funds are available when needed both now and in the future, obtained at the lowest possible cost, and used as efficiently as possible.

Financing priorities are established in line with organizational goals and objectives.

Spending is planned and controlled.

A firm’s credit customers pay their bills on time, and the number of past due accounts is reduced.

Bills are paid promptly to protect the firm’s credit rating and its ability to borrow money.

The funds required for paying the firm’s taxes are available when needed to meet tax deadlines.

Excess cash is invested in certificates of deposit (CDs), government securities, or conservative, marketable securities.

Careers in Finance

Typical job titles in finance include:

Chief financial officer

Vice-president of finance

Bank officer

Consumer credit officer

Financial analyst

Financial planner

Loan officer

Insurance analyst

Investment account executive

In addition to honesty, managers and employees in the finance area must:

TABLE 16-1 Comparison of Short- and Long-Term Financing

Whether a business seeks short- or long-term financing depends on what the money will be used for.

Short-Term Financing Needs

Cash-flow problems	Speculative production
Current inventory needs	Monthly expenses
Short-term promotional needs	Unexpected emergencies

Long-Term Financing Needs

Business start-up costs	Mergers and acquisitions
New product development	Long-term marketing activities
Replacement of equipment	Expansion of facilities

Short-Term Financing

Short-term financing – money that will be used for one year or less

Cash flow – the movement of money into and out of an organization

Speculative production – the time lag between the actual production of goods and when the goods are sold

Long-Term Financing

Long-term financing – money that will be used for longer than one year

The Risk–Return Ratio

Risk–return ratio – a ratio based on the principle that a high-risk decision should generate higher financial returns for a business and more conservative decisions often generate lower returns

Planning—The Basis of Sound Financial Management

Financial plan – a plan for obtaining and using the money needed to implement an organization’s goals and objectives

FIGURE 16-3 The Three Steps of Financial Planning

Developing the Financial Plan

Budget – a financial statement that projects income, expenditures, or both over a specified future period

Cash budget – a financial statement that estimates cash receipts and cash expenditures over a specified period

Most firms use one of two approaches to budgeting.

Traditional approach – a budgeting approach in which each new budget is based on the dollar amounts contained in the budget for the preceding year, the amounts are modified to reflect any revised goals, and managers are required to justify only new expenditures

Zero-base budgeting – a budgeting approach in which every expense in every budget must be justified

To develop a plan for long-term financing needs, managers often construct a capital budget.

Capital budget – a financial statement that estimates a firm’s expenditures for major assets and its long-term financing needs

FIGURE 16-4 Cash Budget for Stars and Stripes Clothing

Traditional Banking Services for Business Clients (1 of 2)

Savings and Checking Accounts

A business with excess cash it is willing to leave on deposit with a bank for a set period of time can earn a higher rate of interest.

To do so, the business firm buys a certificate of deposit.

Certificate of deposit (C D) – a document stating that the bank will pay the depositor a guaranteed interest rate on money left on deposit for a specified period of time

Traditional Banking Services for Business Clients (2 of 2)

Business Loans

Short-term business loans:

Must be repaid within one year or less

To help ensure that short-term money will be available when needed, many firms establish a line of credit.

Line of credit – a loan that is approved before the money is actually needed

Revolving credit agreement – a guaranteed line of credit

Long-term business loans:

Are repaid over a period of years

Most lenders require some type of collateral for long-term loans.

Collateral – real estate or property pledged as security for a loan

Credit and Debit Card Transactions

A recent Gallup poll found that:

Three out of four Americans (76 percent) have at least one credit card.

On average, Americans have 3.4 credit cards.

Half of Americans (48 percent) are carrying credit card debt from one month to the next because they don’t pay their entire credit card debt each month.

By depositing charge slips into a bank or other financial institution, the merchant can convert credit-card sales into cash.

In return for processing the merchant’s credit-card transactions, the financial institution charges a fee that generally ranges between 1.5 and 4 percent.

Debit card – a card that electronically subtracts the amount of a customer’s purchase from her or his bank account at the moment the purchase is made

Electronic Banking Services

Electronic funds transfer (EFT) system – a means of performing financial transactions through a computer terminal

Four EFT applications:

International Banking Services

Letter of credit – a legal document issued by a bank or other financial institution guaranteeing to pay a seller a stated amount for a specified period of time

Certain conditions, such as delivery of the merchandise, may be specified before payment is made.

Banker’s acceptance – a written order for a bank to pay a third party a stated amount of money on a specific date

No conditions are specified; it is simply an order to pay without any strings attached.

Both a letter of credit and a banker’s acceptance are popular methods of paying for import and export transactions.

Sources of Unsecured Short-Term Financing (1 of 3)

Short-term debt financing is usually easier to obtain than long-term debt financing for three reasons:

Most lenders do not require collateral for short-term financing.

Unsecured financing – financing that is not backed by collateral

Sources of Unsecured Short-Term Financing (2 of 3)

Trade Credit

Trade credit – a type of short-term financing extended by a seller who does not require immediate payment after delivery of merchandise

It is the most popular form of short-term financing, because most manufacturers and wholesalers do not charge interest for trade credit.

Promissory Notes Issued to Suppliers

Promissory note – a written pledge by a borrower to pay a certain sum of money to a creditor at a specified future date

Promissory notes usually require the borrower to pay interest.

A promissory note offers two important advantages to the firm extending the credit.

Sources of Unsecured Short-Term Financing (3 of 3)

Unsecured Bank Loans

Prime interest rate – the lowest rate charged by a bank for a short-term loan

Generally is reserved for large corporations with excellent credit ratings

As a condition of an unsecured loan, a bank may require that a compensating balance be kept on deposit at the bank and that every commercial borrower clean up (pay off completely) its short-term loans at least once a year and not use short-term borrowing again for a period of 30 to 60 days.

Commercial Paper

Commercial paper – a short-term promissory note issued by a large corporation

The interest rate a corporation pays when it sells commercial paper is tied to its credit rating and its ability to repay the commercial paper.

Sources of Secured Short-Term Financing

Loans Secured by Inventory

Finished goods, raw materials, and work-in-process inventories may be pledged as collateral for short-term loans.

Loans Secured by Receivables

Accounts receivable – amounts owed to a firm by its customers

A firm can pledge its accounts receivable as collateral to obtain short-term financing.

Factoring Accounts Receivable

Factor – a firm that specializes in buying other firms’ accounts receivable

The factor buys the accounts receivable for less than their face value; however, it collects the full face value dollar amount when each account is due.

The factor’s profit is the difference between the face value of the accounts receivable and the amount the factor has paid for them.

TABLE 16-2 Comparison of Short-Term Financing Methods (1 of 2)

Type of Financing	Cost	Repayment Period	Businesses That May Use It	Comments
Trade credit	Low, if any	30–60 days	All businesses with good credit	Usually no finance charge
Promissory note issued to suppliers	Moderate	One year or less	All businesses	Usually unsecured but requires legal document
Unsecured bank loan	Moderate	One year or less	All businesses	Promissory note is required and compensating balance may be required

TABLE 16-2 Comparison of Short-Term Financing Methods (2 of 2)

Type of Financing	Cost	Repayment Period	Businesses That May Use It	Comments
Commercial paper	Moderate	270 days or less	Large corporations with high credit ratings	Usually available only to large firms
Secured loan	High	One year or less	Firms with questionable credit ratings	Inventory or accounts receivable often used as collateral
Factoring	High	None	Firms that have large numbers of credit customers	Accounts receivable sold to a factor

Selling Stock (1 of 3)

Initial Public Offering and the Primary Market

Initial public offering (I P O) – occurs when a corporation sells common stock to the general public for the first time

When a corporation uses an I P O to raise capital, the stock is sold in the primary market.

Primary market – a market in which an investor purchases financial securities (via an investment bank) directly from the issuer of those securities

Investment banking firm – an organization that assists corporations in raising funds, usually by helping to sell new issues of stocks, bonds, or other investment securities

Selling Stock (2 of 3)

Initial Public Offering and the Primary Market (cont.)

Advantages of selling stock: Equity finance are low for two reasons.

The Secondary Market

Secondary market – a market for existing financial securities that are traded between investors

Usually, secondary-market transactions are completed through a(n):

Selling Stock (3 of 3)

Common Stock

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

Preferred stock – stock whose owners usually do not have voting rights but whose claims on dividends and assets are paid before those of common-stock owners

Retained Earnings

Retained earnings – the portion of a corporation’s profits not distributed to stockholders

Venture Capital, Angel Investors, and Private Placements

Venture capital – money invested in small (and sometimes struggling) firms that have the potential to become very successful

Angel investor – an investor who provides financial backing for small business startups or entrepreneurs

Private placement – occurs when stock and other corporate securities are sold directly to insurance companies, pension funds, large institutional investors, or mutual funds

Sources of Long-Term Debt Financing

Financial leverage – the use of borrowed funds to increase the return on owners’ equity

The principle of financial leverage works as long as a firm’s earnings are larger than the interest charged for the borrowed money.

For a small business, long-term debt financing is generally limited to loans, whereas large corporations have the additional option of issuing corporate bonds.

Long-Term Loans

Term-Loan Agreements

Term-loan agreement – a promissory note that requires a borrower to repay a loan in monthly, quarterly, semiannual, or annual installments

The interest rate and repayment terms for term loans often are based on factors such as:

The lender usually requires some type of collateral.

Lenders may also require that borrowers maintain a minimum amount of working capital.

Corporate Bonds (1 of 3)

Corporate bond – a corporation’s written pledge that it will repay a specified amount of money with interest

Interest rates for corporate bonds vary with the financial health of the company issuing the bond.

Specific factors that increase or decrease the interest rate that a corporation must pay when it issues bonds include:

Most corporate bonds are registered bonds.

Registered bond – a bond registered in the owner’s name by the issuing company

Maturity date – the date on which a corporation is to repay borrowed money

FIGURE 16-7 The Risk–Return Ratio for Corporate Bond Investors

Corporate Bonds (2 of 3)

Types of Bonds

Debenture bond – a bond backed only by the reputation of the issuing corporation

Mortgage bond – a corporate bond secured by various assets of the issuing firm

Convertible bond – a bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock

Corporate Bonds (3 of 3)

Repayment Provisions for Corporate Bonds

Bond indenture – a legal document that details all the conditions relating to a bond issue

A corporation may use one of three methods to ensure it has sufficient funds available to redeem a bond issue.

Trustee – an individual or an independent firm that acts as a bond owner’s representative

TABLE 16-4 Comparison of Long-Term Financing Methods (1 of 2)

Type of Financing	Repayment	Repayment Period	Cost/Dividends/Interest	Businesses That May Use It
Equity
Common stock	No	None	High initial cost; low ongoing costs because dividends not required	All corporations that sell stock to investors
Preferred stock	No	None	Dividends not required but must be paid before common stockholders receive any dividends	Large corporations that have an established investor base of common stockholders

TABLE 16-4 Comparison of Long-Term Financing Methods (2 of 2)

Type of Financing	Repayment	Repayment Period	Cost/Dividends/Interest	Businesses That May Use It
Debt
Long-term loan	Yes	Usually 3–7 years	Interest rates between 3 and 12 percent depending on economic conditions, the financial stability of the company requesting the loan, and the amount of the loan	All firms that can meet the lender’s repayment and collateral requirements
Corporate bond	Yes	Usually 1–30 years	Interest rates between 3.5 and 10 percent depending on the financial stability of the company issuing the bonds and economic conditions	Large corporations that are financially healthy