Introduction to Business II
Chapter 18
Financial Management
Adopted From
Bovee, J.L., and Thill, J.V. (2015), Business in Action, (7th Edition),
Pearson, New York
The Role of Financial Management
Financial management: Planning for a firm’s money needs and
managing the allocation and spending of funds.
1. Balancing short-term and long-term demands
• Must have ready cash to pay salaries, bills, and taxes
• Need a financial cushion to ride out rough times
• May need money for acquisitions or other extraordinary expenses
• Must make strategic long-term investments
2. Balancing potential risks and potential rewards
• Every decision involves a risk/reward trade off
• Higher risks may yield higher rewards
• The safest choices aren’t always the best choices
3. Balancing leverage and flexibility
• Can use debt strategically and sometimes out of necessity
• Debt can be a tool, but it can also be a trap
• Highly leveraged companies have far less ability to manuver and are more
vulnerable to setbacks
The Role of Financial Management
Risk/Return Trade-Off: The balance of potential risks against potential
rewards.
Deveoping a Financial Plan: A document that outlines the funds needed
for a certain period of time, along with the sources and intended uses of
those funds.
Monitoring Cash Flow
Liquidity Crisis having insufficient cash to meet their short-term
needs.
The Role of Financial Management
Managing Accounts Receivabel and Accounts Payable
Accounts receivable: Amounts that are currently owed to a firm.
Accounts payable: Amounts that a firm currently owes to other parties.
Managing Inventory:
Economic Order Quantity (EOQ) or quantity of materials that, when ordered
regularly, results in the lowest ordering and storage costs.
Finding and Allocating Funds
Strategic plan establishes goals,
objectives, priorities
Sources
Financial plan identifies the amounts and types
of Funds of capital needed to accomplish those goals and
objectives
Uses of Funds
Internal Sources Budgets Identify where and when
• Revenue from sales money will be spent
• Investment account
• Revenue from selling
• Payroll
assets Start-up budget: Identifies funds and
• Taxes
spending needed to launch the
• Dividends
company
• Debt repayment
• Rent
External Sources Operating budget: Identifies cash • Utilities
• Credit cards requirements and spending for • Real estate and facilities
• Trade credit current time period • Equipment
• Secured loans • Parts and materials
• Unsecured loans Capital budgets: Plan funding for • Supplies
• Commercial paper major capital investments • Professional services
• Factoring • Advertising and other marketing
• Leases • Training
• Corporate bonds • Research
• Equity Project budgets: Plan funding and • Acquisitions
spending for specific projects • Invetments
Monitoring the Working Capital Accounts
Accounts Receivable Cash Reserves Inventory Accounts Payable
(A/R, or receivables) (A/P, or payables)
• Amounts • Cash or cash • Has the
owed to the potential to be • Amounts the
equivalents
company but converted to company owes
(financial but hasn’t paid
not yet instruments cash but must
received yet.
that can be be sold first
• Need to be converted to • Firms generally
monitored cash quickly) • Represents a wait as long as
closely and • Readily cost while it’s possible to pay
managed available and sitting there unless given
carefully so under the waiting to be incentives to
that the firm company’s sold. pay early
gets the control
revenues it is
expecting on
time
The Budgeting Process
Budget: A Planning and control tool that reflects expected
revenues, operating expenses, and cash receipts and outlays.
Financial Control: The process against cost increases with
contracts that allow a company to buy supplies in the future
at designated prices.
Zero-based budgeting: A budgeting approach in which each
department starts from zero every year and must justify every
item in the budget, rather than simply adjusting the previous
year’s budget amounts.
Budgeting Challenges
1. Every company has a limited amount of money to spend
• Projects and departments are often in competition for resources
• Managers need to make tough choices, occasionally taking money from
one group and giving it to another
2. Revenues and costs are often difficult to predict
• Sales forecasts are never certain, particularly for new products or in sales into new markets
• Fixed costs are easy to predict, but variable costs can be hard to predict, particularly more than a
few months out.
3. It’s not always clear how much should be spent.
• With some expenses, such as advertising, managers aren’t always sure how
much is enough
• Uncertainty leads to budgeting based on past expenditures, which might be
out of line with current strategic needs.
The Budgeting Process
Types of Budgets
Start-up budget: A budget that identifies the money a new company will need
to spend to launch operations.
Operating budget: Also known as the master budget, a budget that identifies
all sources of revenue and coordinates the spending of those funds throughout
the coming year.
Capital budget: A budget that outlines expenditures for real estate, new
facilities, major equipment, and other capital investments.
Capital investments: Money paid to acquire something of permanent value in
a business
Project budget: A budget that identifies the costs needed to accomplish a
particular project
Financing Alternatives: Factors to Consider
Debt financing: Arranging funding by borrowing money.
Equity financing: Arranging funding by selling ownership shares in the
company, publicly or privately.
Short-term financing: Financing used to cover current expenses
(generally repaid within a year.)
Long-term financing: Financing used to cover long-term expenses such
as assets (generally repaid over a period of more than one year.)
Cost of Capital: The average rate of interest a firm pays on its
combination of debt and equity.
Prime Interest: The lowest rate of interest that banks charge for short-
term loans to their most creditworthy customers.
Financing Alternatives: Factors to Consider
Leverage: The technique of increasing the
rate of return on an investment by
financing it with borrowed funds.
Capital structure: A firm’s mix od debt and
equity financing.
Financing Alternatives: Short-Term Debt
Credit Cards
Trade Credit: Credit obtained by a purchaser directly from a supplier.
Secured Loans: Loans backed up with assets that the lender can claim in case
of default, such as a piece of property.
Collateral: A tangible asset a lender can claim if a borrower defaults on a loan.
Unsecured loans: Loans that require a good credit rating but no collateral.
Compensating balance: The portion of an unsecured loan that is kept on
deposit at a lending institution to protect the lender and increase the lender’s
return.
Financing Alternatives: Short-Term Debt
Line of credit: An arrangement in which a financial institution makes
money available for use at any time after the loan has been approved.
Commercial paper: Short-term promissory notes, or contractual
agreements, to repay a borrowed amount by a specified time with a
specified interest rate.
Factoring: Obatining funding by selling accounts receivable.
Financing Alternatives: Long-Term Debt
• Character
• Capacity
• Capital
• Conditions
• Collateral
Financing Alternatives: Long-Term Debt
Lease: An agreement to use an asset in exchange for regular payment;
similar to renting.
Bonds: A method of funding in which the issuer borrows from an
investor and provides a written promise to make regular interest
payments and repay the borrowed amount in the future.
Corporate Bonds
Secured bonds: Bonds backed by specific assets that will be given to
bondholders if the borrowed amount is not repaid.
Debentures: Corporate bonds backed only by the repuatation of the
issue.
Financing Alternatives: Long-Term Debt and Equity
Convertible bonds: Corporate bonds that can be exchanged at the
owner’s discretion into common stock of the issuing company.
Financing Alternatives: Equity
Venture capital and Other Private Equity
Venture Capitalists can invest millions of dollars in companieslong
before those firms can qualify for most other forms of financing.
Private Equity Ownership assets that are^n’t publicly traded; includes
venture capital.
Financing Alternatives: Equity
Public Stock Offering
Steps of Intial Public Offering
1) Preparing the IPO
2) Registering the IPO
3) Selling the IPO
Underwriter: A specialized type of bank that buys the shares from the
company preparing an IPO and sells them to investors.
Prospectus: An SEC-required document that discloses required information
about the company, its finances, and its plans for using the money it hopes to
raise.