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Understanding Business, 6/e
William G. Nickels
James M. McHugh
Susan M. McHugh
Chapter 19: Financial Management
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The PROFILE at the beginning of this chapter is "Getting to Know JOY COVEY, Former CFO of AMAZON.COM." Covey is one of the leading pioneers in the new financial frontier of e-commerce.
  1. THE ROLE OF FINANCE.

    2. Explain the role and importance of finance.
    1. COMPARING THE ACCOUNTANT AND THE FINANCIAL MANAGER.
      2.
      1. The role of an ACCOUNTANT is like a skilled technician who takes measures of a company’s health and writes a report.
        2.
      2. FINANCIAL MANAGERS examine the data prepared by accountants and make recommendations to top management regarding STRATEGIES FOR IMPROVING THE COMPANY’S FINANCIAL STRENGTH.Power Point Presentation
      3. A manager cannot make sound financial decisions without understanding accounting information.
      4. The need for careful financial management remains an ongoing challenge in a business throughout its life.
      5. The MOST COMMON WAYS FOR FIRMS TO FAIL FINANCIALLY are:
        1. UNDERCAPITALIZATION, or not enough funds to start with.
        2. POOR CASH FLOW, or cash in minus cash out.
        3. INADEQUATE EXPENSE CONTROL.
    2. THE IMPORTANCE OF UNDERSTANDING FINANCE.
      1. The text describes a small organization called Parsley Patch, begun on a shoestring budget.
      2. When the owners expanded into the health-food market, sales took off.
      3. Neither woman understood cash flow procedures or how to control expenses, and profits did not materialize.
      4. They eventually hired a CPA and an experienced financial manager, and soon they earned a comfortable margin on operations.
    3. Financial understanding is important to anyone who wants to invest in stocks and bonds or plan a retirement fund.
      4.
  2. WHAT IS FINANCIAL MANAGEMENT? Key Term

    3. Describe the responsibilities of financial managers.

    1. FINANCE is the function in a business responsible for acquiring funds for the firm, managing funds within the firm, and planning for the expenditure of funds on various assets.
      1. Without a carefully calculated business plan, the firm has little chance for survival.
      2. FINANCIAL MANAGEMENT is the job of managing a firm’s resources so it can meet its goals and objectives.
        1. Most organizations will designate a manager in charge of financial operations, generally the CHIEF FINANCIAL OFFICER (CFO.)
        2. Financial management could also be put in the hands of the company TREASURER or vice president of finance.
        3. A COMPTROLLER is the chief accounting officer.
      3. The fundamental task is to obtain money and then plan, use, and control that money effectively.
    2. Both CREDIT and COLLECTIONS are important responsibilities of financial managers.
      1. Financial managers are responsible for collecting overdue payments and minimizing bad debts.
      2. These functions are particularly critical to small and medium-size businesses, which have smaller cash or credit cushions.
    3. Financial managers also handle TAX MANAGEMENT, the analyzing of tax implications of various managerial decisions in an attempt to minimize the taxes paid by the business.
      1. As tax laws change, finance specialists must carefully analyze the tax implications of various decisions in an attempt to minimize taxes paid.
      2. Businesses of all sizes must concern themselves with managing taxes.
    4. It is the INTERNAL AUDITOR, usually a member of the firm’s finance department, who checks on the financial statements to make sure that all transactions are appropriate.
      1. Without such audits, accounting statements would be less reliable.
      2. It is important that internal auditors be objective and critical of any improprieties or deficiencies.
    5. Accounting and finance are MUTUALLY SUPPORTIVE functions in a firm.
  3. FINANCIAL PLANNING. Power Point Presentation

    4. Tell what financial planning involves and define the three key budgets of finance.
    1. Financial planning involves analyzing short-term and long-term money flows to and from the firm.Concept Check CONCEPT CHECK
      1. The major objective of financial planning is TO OPTIMIZE PROFITS AND MAKE THE BEST USE OF MONEY.
      2. The steps involved in FINANCIAL PLANNING are:
        1. The steps involved in FINANCIAL PLANNING are:
        2. DEVELOPING BUDGETS to meet those needs.
        3. ESTABLISHING FINANCIAL CONTROL to see how well the company is following the financial plans.
    2. FORECASTING FINANCIAL NEEDS.
      1. A SHORT-TERM FORECAST is a prediction of revenues, costs, and expenses for a period of one year or less.
      2. A CASH FLOW FORECAST is a prediction of cash inflows and outflows in future periods, usually months or quarters.
        1. The inflows and outflows of cash are based on expected sales revenues and on various costs and expenses.
        2. A firm often uses its past financial statements as a basis for projecting expected sales and various costs and expenses.
      3. LONG-TERM FORECAST is a prediction of revenues, costs, and expenses for a period longer than 1 year, sometimes extending 5 or 10 years into the future.
        1. This forecast plays a crucial part in the company’s long-term strategic plan.
        2. The long-term financial forecast gives managers an idea of the income or profit potential with different strategic plans.
    3. WORKING WITH THE BUDGET PROCESS.Concept Check CONCEPT CHECK
      1. A BUDGET is a financial plan.
        1. A budget becomes the primary basis and guide for the firm’s financial operations.
        2. Most firms compile yearly budgets from short-term and long-term financial forecasts.
      2. There are SEVERAL BUDGETS IN A COMPANY:
        1. The CAPITAL BUDGET highlights a firm’s spending plans for major assets purchased that required large sums of money.
        2. The CASH BUDGET estimates a firm’s projected cash balance at the end of given period.
        3. The OPERATING BUDGET, or MASTER BUDGET, ties together all of a firm’s other budgets; it is the projection of dollar allocations to various costs and expenses needed to run the business.
      3. Financial planning often determines:
        1. What long-term investments are made.
        2. When specific funds will be needed.
        3. How the funds will be generated.
    4. ESTABLISHING FINANCIAL CONTROLS.
      1. FINANCIAL CONTROL is a proces in which a firm periodically compares its actual revenues, costs, and expenses to those projected.
      2. Most companies hold at least monthly financial reviews as a way to ensure financial control.
      3. Such controls provide feedback to help reveal which accounts are varying from the financial plans.
      4. Some financial adjustments to the plan may be made.
  4. THE NEED FOR OPERATING FUNDS.

    5. Recognize the financial needs that must be met with available funds.
    1. In business, the need for operating funds never seems to cease.
      1. Continuous sound financial management is essential because the CAPITAL NEEDS OF BUSINESS CHANGE OVER TIME.
      2. Funds must be available to finance specific operational needs.
    2. MANAGING DAILY BUSINESS OPERATIONS.Power Point Presentation
      1. Funds must be made available to meet these daily cash expenditures without compromising the investment potential of the firm’s money.
      2. Money has TIME VALUE—$200 today is more valuable that $200 a year from today.
      3. Financial managers often try to keep cash expenditures to a minimum to free funds for investment in interest-bearing accounts.
      4. Efficient cash management is particularly important to small firms.
        5.
    3. MANAGING ACCOUNTS RECEIVABLE.
      4.
      1. Making credit available helps keep current customers happy and attracts new ones.
        2.
      2. The major problem with credit purchasing is that as much as 25% OF A COMPANY’S ASSETS CAN BE TIED UP IN ACCOUNTS RECEIVABLE.Concept Check CONCEPT CHECK
      3. The firm needs to use some of its available funds to pay for the goods or services already given to customers.
      4. In order to collect this money as soon as possible, financial managers offer such INCENTIVES as cash or quantity discounts to purchasers who pay their account by a certain time.
      5. One way to decrease the time and expense of collecting accounts receivable is to ACCEPT BANK CREDIT CARDS such as MasterCard or Visa.
        6.
    4. OBTAINING NEEDED INVENTORY.
      1. To satisfy customers, businesses must maintain INVENTORIES that involve a sizable expenditure of funds.
      2. A carefully constructed inventory policy assists in managing the use of the firm’s available funds and maximizing profitability.
      3. JUST-IN-TIME INVENTORY may help reduce the funds companies must use to maintain inventories.
    5. MAJOR CAPITAL EXPENDITURES.
      1. CAPITAL EXPENDITURES are major investments in long-term assets such as land, buildings, equipment, or R&D.
      2. The purchase of major assets require huge expenditures.
        1. It is critical that the firm weigh all possible options before it commits a large portion of its available resources.
        2. Financial managers must evaluate the appropriateness of capital expenditures.
  5. ALTERNATIVE SOURCES OF FUNDS.

    6. Distinguish between short-term and long-term financing and between debt capital and equity capital.
    1. SHORT-TERM VERSUS LONG-TERM FUNDS.
      1. SHORT-TERM FINANCING refers to borrowed capital that will be repaid within one year and helps finance current operations.
      2. LONG-TERM FINANCING refers to borrowed capital for major purchases that will be repaid over a specific time period longer than one year.
        3.
    2. METHODS OF RAISING CAPITAL.
      1. DEBT CAPITAL refer to funds raised through various forms of borrowing that must be repaid.
      2. EQUITY CAPITAL Key Term is money raised from within the firm or through the sale of ownership in the firm.
  6. OBTAINING SHORT-TERM FINANCING.Power Point Presentation

    7. Identify and describe several sources of short-term financing.
    1. Everyday operation of the firm calls for careful management of short-term financial needs.Concept Check CONCEPT CHECK
    2. TRADE CREDIT.
      1. The most widely used source of short-term funding, trade credit, is the least expensive and most convenient form of short-term financing.
      2. TRADE CREDIT is the practice of buying goods now and paying for them later or paying for them early and getting a discount.
      3. Terms such as "2/10, net 30" means that the buyer can take a 2 percent discount for paying within 10 days, and the total bill is due in 30 days if the discount is not taken.
    3. PROMISSORY NOTES.
      1. For organizations with a poor credit rating or history of slow payment, the supplier may insist that the customer sign a promissory note.
      2. A PROMISSORY NOTE is a written contract with a promise to pay.
    4. FAMILY AND FRIENDS.
      1. It is better not to borrow from friends and relatives.
      2. Entrepreneurs have come to rely less and less on family and friends for funding.
      3. If you borrow from family or friends it is best to:
        1. AGREE ON SPECIFIC LOAN TERMS AT THE BEGINNING.
        2. PUT THE AGREEMENT IN WRITING.
        3. ARRANGE FOR REPAYMENT IN THE SAME WAY YOU WOULD A BANK LOAN.
          4.
    5. COMMERCIAL BANKS AND OTHER FINANCIAL INSTITUTIONS.
      1. Banks are highly sensitive to risk and often reluctant to loan money to small business.
        1. The most promising ventures are sometimes able to get bank loans.
        2. The person in charge of finance should keep in close touch with the bank and see the banker periodically.
        3. How much a business borrows and for how long depend on:
          1. The kind of business it is.
          2. How quickly the merchandise purchased with a bank loan can be resold or used to generate funds.
        4. Sometimes a business gets so far into debt that the bank refuses to lend it more funds.
          1. Often the business fails.
          2. This result can be chalked up to cash flow problems.
        5. By anticipating times when many bills will come due, a business can begin early to seek funds and prepare for the crunch.
        6. A banker’s advice at this point can help the firm.
    6. DIFFERENT FORMS OF BANK LOANS.
      1. A SECURED LOAN is a loan that’s backed by something valuable, such as property.
        1. The item of value is called COLLATERAL.
        2. Accounts receivable can be quickly converted into cash, and are often used as security.
        3. The process of using accounts receivable or other assets as collateral for a loan is PLEDGING.
        4. INVENTORY FINANCING Key Term is the process of using inventory such as raw materials as collateral for a loan.
      2. UNSECURED LOANS, loans that are not backed by collateral, are the most difficult to get—only highly regarded customers are approved.
      3. LINE OF CREDIT means that bank will lend the business a given amount of unsecured short-term funds, provided the bank has the funds available.
        1. A line of credit is not guaranteed.
        2. The purpose of a line of credit is to speed the borrowing process.
        3. As businesses mature and become more financially secure, the amount of credit often is increased.
        4. REVOLVING CREDIT AGREEMENT is a line of credit that is guaranteed.
      4. COMMERCIAL FINANCE COMPANIES make short-term loans to borrowers that offer tangible assets as collateral.
        1. Commercial finance companies are willing to accept higher degrees of risk than commercial banks.
        2. Interest rates charged are usually higher than banks.
    7. FACTORING.Concept Check CONCEPT CHECK
      1. FACTORING, the process of selling accounts receivable for cash, is relatively expensive.
      2. A FACTOR is a market intermediary that agrees to buy the accounts receivable from the firm at a discount for cash.
      3. The factor then collects and keeps the money that was owed the firm.
      4. Factoring is very popular among small businesses.
      5. Factoring is not a loan—it is the sale of an asset.
      6. Factoring charges are much lower if the company assumes the risk of those accounts who don’t pay at all.
        7.
    8. COMMERCIAL PAPER.
      1. COMMERCIAL PAPER consists of unsecured promissory notes in amounts of $25,000 and up that mature in 270 days or less.
      2. Commercial paper is unsecured and is sold at a public sale, so ONLY FINANCIALLY STABLE FIRMS are able to sell it.
      3. Some large companies are considering selling commercial paper over the Internet.
      4. It is an investment opportunity for buyers who can put up cash for short periods.
  7. OBTAINING LONG-TERM FINANCING.Concept Check CONCEPT CHECK

    8. Identify and describe several sources of long-term financing.
    1. The FINANCIAL PLAN specifies the amount of funding that the firm will need over various time periods and the most appropriate sources of those funds.
      1. In setting long-term financing objectives, the firm generally asks three major questions:
        1. What are the organization’s long-term GOALS AND OBJECTIVES?
        2. What are the FINANCIAL REQUIREMENTS needed to achieve these goals and objectives?
        3. What SOURCES of long-term capital are available, and which best fit our needs?
      2. LONG-TERM CAPITAL is used to buy fixed assets such as plant and equipment and to finance any expansions of the organization.
      3. Long-term financing usually comes from two sources: DEBT CAPITAL or EQUITY CAPITAL. Power Point Presentation
    2. DEBT FINANCING.
      1. DEBT CAPITAL are funds that come to the firm from borrowing through lending institutions or from the sale of bonds.
        1. With debt financing, the firm has a legal obligation to repay the amount borrowed.
        2. Long-term loans are usually repaid within 3 to 7 years, but may extend to 15 or 20 years.
        3. A TERM-LOAN AGREEMENT is a promissory note that requires the borrower to repay the loan in specified installments.
        4. A major advantage is that interest paid on a long-term debt is tax deductible.
      2. LONG-TERM LOANS are often more expensive than short-term loans because larger amounts of capital are borrowed and the repayment date is less secure.
        1. Most long-term loans require some form of COLLATERAL.
        2. Lenders will also often require certain RESTRICTIONS on a firm’s operations.
        3. The greater risk a lender takes, the higher rate of interest it requires, known as the RISK/RETURN TRADEOFF.
      3. If an organization is unable to obtain its long-term financing needs from a lending institution, it may decide to issue bonds.
        1. A BOND is a company IOU, a binding contract through which an organization agrees to specific terms with investors in return for investors lending money to the company.
        2. INDENTURE TERMS are the terms of agreement in a bond.
    3. SECURED AND UNSECURED BONDS.
      1. A BOND is a long-term debt obligation of a corporation or government.
      2. Investors in bonds measure the RISK involves in purchasing a bond with the RETURN (interest) the bond promises to pay.
      3. SECURED BONDS are issued with some form of collateral, such as real estate, equipment, or other pledged collateral, such as real estate, equipment, or other pledged assets.
      4. UNSECURED BONDS are bonds backed only by the reputation of the organization and bondholders’ trust in the issuer.
    4. EQUITY FINANCING.
      1. EQUITY FINANCING comes from the owners of the firm.
      2. It involves selling ownership in the firm in the form of stock, or using retained earnings the firm has reinvested in the business.
      3. A business can also seek equity financing from venture capital.
        4.
    5. SELLING STOCK.
      1. One way to obtain need funds is to sell OWNERSHIP SHARES (STOCK) in the firm to the public.
      2. Purchasers of stock become OWNERS in the organization.
      3. Shares of stock the company decides not to offer for sale are known as UNISSUED STOCK, or TREASURY STOCK.
      4. Companies can only issue stock for public purchase if they meet requirements set by the Security and Exchange Commission (SEC.)
      5. The terminology and intricacies of selling stock to raise funds is discussed in the next chapter.
    6. RETAINED EARNINGS is the profit the company keeps and reinvests in the firm.
      1. This is often a MAJOR SOURCE OF LONG-TERM FUNDS.
      2. Retained earnings are usually the most favored source of meeting long-term capital needs because:
        1. The company saves interest payments, dividends, and underwriting fees.
        2. There is no dilution of ownership.
      3. The major problem is that many organizations do not have sufficient retained earnings.
    7. VENTURE CAPITAL. Key Term
      1. The hardest time for a business to raise money is when it is just starting.
      2. Venture capital firms are one of the sources of start-up capital for new companies.
      3. VENTURE CAPITAL MONEY is invested in new companies with great profit potential.
      4. The venture capital industry began about 50 years ago as an alternative investment vehicle for wealthy families.
        1. The venture capital industry grew significantly in the 1980s.
        2. In the 1990s, venture capital investment increased, especially in high-tech centers.
        3. Venture capitalist investments have recently reached into international markets.
      5. Venture capitalist investments have recently reached into international markets.
      6. The search for venture capital begins with a good business plan.
      7. Financing a firm’s long-term needs clearly involves a high degree of risk.
        8.
    8. MAKING DECISIONS ON USING LEVERAGE.
      1. LEVERAGE is raising needed funds through borrowing to increase the rate of return.
      2. While debt increases the risk of the firm, it also enhances the firm’s profitability.
      3. If the firm’s earnings are larger than the interest payments on the funds borrowed, stockholders earn a higher rate of return than if equity financing were used.
      4. It is up to each firm to determine exactly what is a proper balance between debt and equity financing.
      5. The average debt of a large industrial corporation ranges between 33 and 40% of its total assets.
    9. The next chapter looks at stocks and bonds and other investment topics.
      10.




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