Financial Management
Every business needs money to operate, grow, purchase assets, pay employees, and meet its obligations. Finance is the business function that acquires funds for a firm and manages those funds within the firm. Financial management is the job of managing a firm's resources so the organization can meet its goals and objectives.
Financial managers examine financial data and recommend strategies for improving financial performance. Their responsibilities connect closely with accounting, but finance focuses especially on planning, obtaining, allocating, and controlling financial resources.
The Role of Financial Managers
Financial managers help determine where a company's money will come from and how it will be used. Their activities include preparing budgets, creating cash-flow analyses, planning expenditures, paying bills, collecting payments, monitoring financial markets, and helping ensure the accuracy of financial information.
Common finance-related positions include the Chief Financial Officer (CFO), Certified Financial Planner (CFP), Chartered Financial Analyst (CFA), and comptroller or chief accounting officer.
Why Firms Fail Financially
A promising business can still fail if its finances are poorly managed. Three important financial problems are undercapitalization, poor control over cash flow, and inadequate expense control. A company may have customers and sales but still struggle if it does not have enough cash available when obligations come due.
Financial managers must also respond to outside pressures such as consumer demand, government policies, competitors' pricing, credit markets and interest rates, and global financial instability. Inside the company, they must consider margins, forecasts, productivity, costs, and working-capital needs.
Financial Planning
Financial planning involves analyzing short-term and long-term flows of money into and out of the company. The chapter identifies three major steps:
- Forecast the firm's short-term and long-term financial needs.
- Develop budgets to meet those needs.
- Establish financial controls to determine whether the company is achieving its financial goals.
Financial Forecasting
A short-term forecast predicts revenues, costs, and expenses for one year or less. A cash-flow forecast predicts cash inflows and outflows in future periods, usually by month or quarter. A long-term forecast predicts revenues, costs, and expenses for periods longer than one year and may extend five or ten years into the future.
Forecasts help managers anticipate financing needs rather than waiting for a cash shortage or other financial problem to occur.
Budgets
A budget states management's expectations for revenues and allocates the use of resources throughout the firm. Budgets depend heavily on information from the balance sheet, income statement, statement of cash flows, and financial forecasts.
- Capital budget — highlights spending plans for major asset purchases that often require large amounts of money.
- Cash budget — estimates cash inflows and outflows during a particular period, such as a month or quarter.
- Operating (master) budget — ties together the firm's other budgets and summarizes its proposed financial activities.
Financial Control
Financial control is the process of periodically comparing actual revenues, costs, and expenses with the budget. These comparisons help managers identify accounts, departments, or activities that are varying from the financial plan and determine whether corrective action is needed.
Financial controls can help managers ask whether the firm is meeting short-term commitments, earning adequate operating profits, financing its assets appropriately, and providing owners with an acceptable return.
Why Businesses Need Operating Funds
Businesses need funds for day-to-day operations as well as long-term growth. Uses include managing daily cash needs, controlling credit operations, acquiring inventory, and making capital expenditures. Timing matters because cash payments and cash receipts do not always occur at the same time.
Small businesses may improve cash flow by collecting accounts receivable more aggressively, offering discounts for early payment, taking advantage of favorable vendor terms, adjusting prices, and using credit carefully.
Debt Financing and Equity Financing
Businesses have two broad ways to obtain funds. Debt financing consists of funds raised through borrowing that must be repaid. Equity financing consists of funds raised from within the firm through operations or through the sale of ownership, such as stock.
The appropriate financing choice depends on how much money is needed, how long it will be needed, the firm's financial condition, the cost of financing, and the owners' willingness to share ownership or accept additional debt.
Short-Term Financing
Short-term financing provides funds needed for one year or less. Businesses may need short-term financing because of seasonal sales patterns, unexpected cash shortages, inventory purchases, or timing differences between paying expenses and collecting customer accounts.
Trade Credit and Promissory Notes
Trade credit is the practice of buying goods or services now and paying for them later. A common example is a supplier offering terms such as 2/10, net 30. Under those terms, the buyer may take a 2 percent discount by paying within 10 days; otherwise the full amount is due within 30 days.
A promissory note is a written contract agreeing to pay a supplier a specific amount of money at a definite time.
Family, Friends, and Bank Financing
Some small firms obtain financing from friends or family. Even when the parties know one another well, loan terms should be specific, written down, and treated professionally.
Commercial banks offer several forms of short-term credit. A secured loan is backed by collateral, while an unsecured loan does not require collateral. A line of credit makes an approved amount of money available to the borrower, while a revolving credit agreement is a guaranteed line of credit that generally carries a fee.
Factoring
Factoring is the process of selling accounts receivable for cash. A factor provides the company with cash before customers actually pay their accounts. Factoring may be more expensive than conventional bank financing, but it can provide access to cash for firms that cannot qualify for traditional loans.
Commercial Paper and Credit Cards
Commercial paper consists of unsecured promissory notes in amounts of $100,000 or more that mature in 270 days or less. Because it is unsecured, it is generally available only to financially stable companies.
Credit cards can also provide short-term financing and convenience, especially for small businesses, but their cost can make them an expensive source of funds.
Long-Term Financing
Long-term financing provides funds needed for more than one year. Before selecting a source, financial managers should consider the organization's long-term goals, determine how much funding is required to achieve those goals, and evaluate which available sources of capital best fit the firm's needs.
The Five Cs of Credit
Lenders commonly evaluate borrowers using the Five Cs of Credit:
- Character — the borrower's reputation and willingness to repay.
- Capacity — the borrower's ability to repay the loan.
- Capital — the amount the borrower has invested in the business.
- Conditions — economic and industry conditions affecting the borrower.
- Collateral — assets available to secure the loan.
Long-Term Debt and Term Loans
Long-term loans may extend for several years. A term-loan agreement is a promissory note requiring the borrower to repay a loan with interest in specified monthly or annual installments. One advantage of debt financing is that interest paid by the firm is generally treated as a deductible business expense.
Lenders may place restrictions in loan agreements to protect their investment and encourage responsible financial management.
Financing Through Bonds
Corporations can also borrow by issuing bonds. Indenture terms are the terms of agreement in a bond issue. A secured bond is backed by some form of collateral, such as real estate. An unsecured bond, also called a debenture bond, is backed by the reputation and creditworthiness of the issuing company rather than specific collateral.
Equity Financing
A company can obtain equity financing by selling shares of stock, retaining profits and reinvesting them in the firm, or attracting outside investors. Venture capital is money invested in new or emerging companies that investors believe have significant profit potential.
Venture capitalists evaluate whether a company can grow, whether their investment is likely to be returned with a profit, and whether the expected return justifies the money and effort required.
Debt Versus Equity
Debt and equity financing each have advantages and disadvantages. Debt allows owners to obtain funds without giving up ownership, but the borrowed money and interest must be repaid. Equity financing does not create the same repayment obligation, but issuing ownership may reduce the existing owners' control and share of future profits.
Financial managers must evaluate the benefits and drawbacks of both approaches when determining an appropriate capital structure.
Leverage and Cost of Capital
Leverage is raising funds through borrowing in an effort to increase the firm's rate of return. Borrowing can magnify returns when investments perform well, but it also creates fixed financial obligations and therefore increases financial risk.
Cost of capital is the rate of return a company must earn to meet the demands of lenders and the expectations of equity holders. Financing decisions should therefore consider not merely whether money is available, but also what that money costs the business.
Putting Chapter 18 Together
Financial management connects a firm's goals with the money required to achieve them. Managers forecast financial needs, prepare budgets, monitor results, maintain cash flow, and select appropriate short- and long-term sources of financing. The central challenge is to obtain and use capital wisely while balancing cost, risk, repayment obligations, ownership, and the firm's long-term objectives.