Chapter
Twenty
Mastering Financial
Management
Learning Objectives
1. Explain the need for financing and financial
management in business.
2. Summarize the process of planning for
financial management
3. Describe the advantages and disadvantages
of different methods of short-term debt
financing.
4. Evaluate the advantages and disadvantages
of equity financing.
5. Evaluate the advantages and disadvantages
of long-term debt financing.
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What Is Financial Management?
• All the activities concerned with
obtaining money and using it
effectively
– Determining the best ways to raise
money
– Ensuring money is used in keeping
with the organization’s goals
– Planning
• The need for financing
– When expenses are high or sales
are low
– Opportunities to expand
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The Need for 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
• Inventory—speculative production (the time lag
between the actual production of goods and
when the goods are sold)
• Long-term financing
– Money that will be used for longer than one
year
– Often involves large amounts of money
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Cash Flow for a Manufacturing Business
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Comparison of Short- and Long-Term
Financing
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The Need for Financial Management
• Proper financial management can
ensure that
– Financing priorities are in line
with organizational goals and
objectives
– Spending is planned and
controlled
– Sufficient financing is available
when it is needed
– Excess cash is invested in
interest-bearing securities
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Careers in Finance
• Skills and traits of successful financial managers
–
–
–
–
Responsible and honest
Strong background in accounting or math
Knowledge of how to use a computer to analyze data
Expert in written and oral communications
• Jobs
–
–
–
–
–
–
Bank officer
Credit officer
Financial analyst
Financial planner
Insurance analyst
Investment account executive
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Planning—The Basis of Sound
Financial Management
• Financial plan
– A plan for obtaining and using
the money needed to implement
an organization’s goals
• Developing the financial plan
– Establishing organizational
goals and objectives
– Budgeting for financial needs
– Identifying sources of funds
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The Three Steps of Financial Planning
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Developing the Financial Plan
• Establishing goals and objectives
– Goal
• An end state that the organization
expects to achieve over a 1- to
10-year period
– Objectives
• Specific statements detailing what
the organization intends to
accomplish within a certain period
of time
– Must be specific and measurable
– Must be realistic
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Developing the Financial Plan (cont’d)
• Budgeting for financial needs
– Budget
• A financial statement that projects income and/or
expenditures over a specified future period
• Usually begins with sales and various types of expenses
– Cash budget
• Projects cash receipts and expenditures over a specified
future period
• Traditional
– Based on dollar amounts in budget for preceding year
• Zero-based budgeting
– Every expense in every budget must be justified
– Capital budget
• Estimates a firm’s expenditures for major assets and its
long-term financing needs
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Sales Budget for Stars and
Stripes Clothing
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Cash Budget for Stars and
Stripes Clothing
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Developing the Financial Plan (cont’d)
• Identifying sources of funds
– Sales revenues
• Provide the greatest part of the firm’s financing
– Equity capital
• Money received from the owners or from the sale
of shares of ownership in the business; long-term
financing
– Debt capital
• Borrowed money obtained through loans
– Proceeds from the sale of assets
• If absolutely necessary or when no longer needed
• Monitoring and evaluating financial
performance
– Prevents minor problems from becoming major
ones
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Short-Term Debt Financing
• Short-term financing is usually
easier to obtain than long-term
– Shorter repayment period
means less risk of
nonpayment
– Amounts of short-term loans
are smaller than long-term
loans
– There is a closer relationship
between borrower and lender
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Sources of Unsecured Short-Term
Debt Financing
• Unsecured financing
– Financing not backed by collateral
• Trade credit
– Financing extended by a seller who does not require
immediate payment after the delivery of the
merchandise
• Promissory notes
– A written pledge by a borrower to pay a certain sum of
money to a creditor at a specified future date
– Unlike trade credit, promissory notes usually include
interest
– Legally binding
– Negotiable instruments
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Sources of Unsecured Short-Term
Debt Financing (cont’d)
• Unsecured bank loans
– Interest rates vary with each
borrower’s credit rating
– Prime interest rate
• The lowest rate charged by a bank
for a short-term loan
– Offered through promissory notes, a
line or credit, or revolving credit
agreement
• Commercial paper
– Short-term promissory note issued
by a large corporation
– Interest rates are usually below that
charged by banks for short-term
loans
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Average Prime Interest Rate
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Sources of Secured Short-Term
Debt Financing
• Loans secured by inventory
– Inventory is pledged as collateral
– Control of the inventory passes to the lender
until the loan is repaid
– The borrow must pay storage for the
inventory
– Floor planning
• The title to the inventory is given to lenders in
return for short-term financing
• The borrow maintains control of the inventory
• Loans secured by receivables
– Amounts owed the firm in the form of
accounts receivable from trade credit given
to customers are pledged as collateral
– Quality of receivables is considered
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Factoring Accounts Receivable
• Another method of raising short-term financing
• Factor
– A firm that specializes in buying other firms’ accounts
receivable
• The factor buys accounts receivable for less than
their face value
• The factor collects the full dollar amounts when each
account is due
• The factor’s profit is the difference between the face
value and what it paid for the accounts receivable
• Profit is based on the risk (probability that the
accounts receivable will not be paid) the factor
assumes
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Comparison of Short-Term Financing
Methods
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Sources of Equity Financing
• For sole proprietorships
or partnerships
– Owner or owners invest
money in the business
– Venture capital
• For corporations
– Sale of stock
– Use of profits not
distributed to owners
– Venture capital
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Sources of Equity Financing (cont’d)
• Selling stock
– Initial public offering
• When a corporation sells common
stock to the general public for the first
time
– Advantages of selling stock
• Firm does not have to repay money
received from sale of stock
• Firm does not have to pay dividends to
stockholders
– Two types of stock
• Common stock
• Preferred stock
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Sources of Equity Financing (cont’d)
• Selling stock (cont’d)
– 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
• Stock whose owners usually do not have voting rights,
but whose claims on dividends and assets are paid
before those of common-stock owners
– Par value
• An assigned (and often arbitrary) dollar value printed on
a stock certificate
– Convertible preferred stock
• Preferred stock that the owner may exchange for a
specified number of shares of common stock
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Sources of Equity Financing (cont’d)
• Retained earnings
– The portion of a corporation’s profits not
distributed to stockholders
• Venture capital
– Money invested in a firm with the
expectation that the firm has the
potential to become
very successful and increase in value
– Investors usually receive an equity
position in the business and share in its
profits
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Sources of Long-Term Debt Financing
• Financial leverage
– The use of borrowed funds to increase the return on
owners’ equity
– As long as the firm’s earnings are larger than the
interest charged for the borrowed money, there is a
positive effect on return on owners’ equity
• Lease
– An agreement by which the right to use real estate,
equipment, or other assets is temporarily transferred
from the owner to the user
– Sometimes used if a firm cannot obtain a loan to
acquire property, buildings, or equipment
– Can have tax advantages over long-term debt
financing
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Effects of Additional Capital
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Sources of Long-Term
Debt Financing (cont’d)
• Long-term loans
– Term-loan agreement
• For loans longer than 1 year
• A promissory note that requires a borrower to repay a loan in
monthly, quarterly, semiannual, or annual installments
– Interest rate and repayment terms are based on the reasons
for borrowing, the firm’s credit rating, the value of collateral
– Getting a loan
• Know potential lenders
• Maintain a good credit rating
• Fill out an application; submit a business
plan and financial statements; compile references
• Meet with loan officer
• If denied, determine why
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Sources of Long-Term
Debt Financing (cont’d)
• Corporate bonds
– A corporation’s written pledge that it will repay a
specified amount of money with interest
– Maturity date—the date on which the corporation is to
repay the borrowed money
– Interest is paid until maturity
– Types of bonds
• Registered bond—a bond registered in the owner’s name
by the issuing company
• Debenture bond—a bond backed only by the reputation
of the issuing corporation
• Mortgage bond—a 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
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Sources of Long-Term
Debt Financing (cont’d)
• Corporate bonds (cont’d)
– Repayment provisions for corporate bonds
• Bond indenture—a legal document that details
all the conditions relating to a bond issue
• Call premium—an amount paid to the bond
owner if the corporation buys back the bond
before the maturity date
• Serial bonds—bonds of a single issue that
mature on different dates
• Sinking fund—a sum of money to which
deposits are made each year for the purpose
of redeeming a bond issue
• Trustee—an individual or an independent firm
that acts as the bond owners’ representative
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Comparison of Long-Term Financing
Methods
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