Chapter 17

The Financial System

Finance: The business function of planning, obtaining and managing the company’s funds to
accomplish its objectives as effectively and efficiently as possible

Financial Managers: The executives who develop and carry out the firm’s financial plan and
decide on the most appropriate sources and uses of funds

Roles of Financial Managers

CEO

- At the top of the finance organization in a typical firm

- CFO reports to CEO

CFO

- Reports to CEO
- In some cases is also a member of the board of directors
- CFO and CEO must both certify accuracy of firm’s financial statements
- Reported to by Treasurer, Controller and Vice-President of Financial Planning

Vice President of Financial Planning

- Responsible for preparing financial forecasts and analyzing major investment decisions

Treasurer

- Responsible for all of the company’s financing activities

- Also works on sale of new security issues to investors

Controller

- Controller Is the chief accounting manager

- Responsible for keeping company’s books, preparing financial statements etc.

Risk Return Trade-off: The process of maximizing the wealth of the firm’s shareholders by
striking right balance between risk and return

- Risk is uncertainty of gain or loss; return is the gain or loss that results from an
investment
 - Financial managers try to maximize return of shareholders by striking right balance
between risk and return

Financial Plan: A document that specifies the funds needed by a firm for a given period of time,
timing of cash inflows and outflows, and most appropriate sources and uses of funds

Operating Plan: A short term financial plan that focuses on no more than a year or two in the
future

Strategic Plan: Financial plans that have a much longer time horizon, up to 5 or 10 years

Questions to ask when building a Financial Plan

- What funds will firm require during the planning period?

- When will the firm need additional funds?
- Where will the firm obtain the necessary funds?

Steps Involved in Preparing a Financial Plan

1. Forecast of Sales/Revenue

- Projection is key variable in any financial plan

- Retailer CFO can look at current sales per store, expected sales growth and planned
store opening/closing to obtain projections

2. Forecast of Expected Level of Profits

- Long-term projection involves estimating expenses

- CFO must decide what portion of profits will be paid as cash dividends

3. Estimate Additional Assets Required

- Increase in sales will mean increased requirement of assets

- Depending on type of industry, some firms may need more assets than other business
to support same amount of sales
- We say different firms have different asset intensities
- If a firm needs more assets for an additional sale compared to another firm, it is more
asset intensive

Financial Control: Process of comparing actual revenues, costs and expenses with the
forecasted amounts

Short Term Assets

Cash and Marketable Securities

- Most organizations try to keep a minimum cash balance so they have funds available for
unexpected expenses
- However cash earns little to no return, so firms look to invest excess cash in marketable
securities
- Marketable securities are low risk and can be easily sold in secondary markets

Accounts Receivable

- AR’s are uncollected credit sales, and can represent a significant asset
- Financial Manager must collect funds owed as quick as possible whilst still offering
sufficient credit to customers
- Management of accounts receivable is comprised of two functions:
o Deciding overall credit policy
o Deciding which customers will be offered credit
- Calculate accounts receivable turnover over two or more time periods in arrow to assess
how well receivables are being managed
- If receivables turnover shows signs of slowing, means that on average, credit customers
are paying later

Inventory Management

- For many firms, inventory represents largest single asset

- Most firms carry inventory, and their proper management of inventory is vital to
business success
- Cost of inventory includes
o Cost of acquiring goods
o Cost of ordering and storing goods
o Cost of insuring and financing goods
- Financial managers try to minimize cost of inventory
- If inventory turnover has been slowing for several quarters in a row, inventory is rising
faster than sales, and may suggest customer demand is slowing

Capital Investment Analysis

- Firm’s also invest in long-lived assets

- CIA is process financial managers use when deciding whether to invest in long-lived
assets
- Firms make two basic types of capital investment decisions
o Expanding Capital
o Replacing Capital
Debt Capital: Consists of funds acquired through borrowing

Equity Capital: Consists of funds provided by firm’s owners when they reinvest their earnings,
make additional contributions, liquidate assets etc.

Capital Structure: Mix of a firm’s debt and equity capital

Leverage: Increasing the rate of return on funds invested by borrowing funds

- As a company uses more debt capital, its risk increases

- Debt is frequently the least costly method of raising additional financing dollars
- Choosing more debt increases fixed costs a company must pay
- Key to managing leverage is to ensure a company’s earnings remain larger than its
interest payments
- Leverage increases potential returns to shareholders, but also increases risk
- Another problem with borrowing money is relying too much on borrowed funds may
reduce management flexibility on future financing decisions
- Equity capital is more expensive than debt capital

Dividends: Periodic cash payments to shareholders. Most common type of dividend is paid
quarterly and is often called a regular dividend

- Main factor in deciding on a firm’s dividend policy is its investment opportunities

- Firm’s with more profitable investment opportunities often pay less in dividends than
firms with fewer such options

Sources of Short-Term Financing for Businesses

Trade Credit

- TC is extended by suppliers when a firm receives goods or services and agrees to pay for
them at a later date
- Common in industries such as retailing and manufacturing
- To record, supplier enters transactions as an account receivable, retailer enters it as an
account payable
- Main upside is easy availability, main downside is the amount a company can borrow is
limited to amount it purchases
- If suppliers don’t offer a cash discount, trade credit is effectively free
- If cash discount is offered, trade credit can get expensive

Short-Term Loans
 - Businesses often use loans from commercial banks to finance inventory and accounts
receivable
- Borrowers can choose from two types of bank loans:
o Lines of Credit
 Specifies maximum amount firm can borrow over a period of time
 Bank will only lend money if funds are available
 Most LOC’s require borrower to pay original amount + interest within one
year
o Factoring
 Business sells its accounts receivable at a discount to either a bank or a
finance company
 Cost of the transaction depends on size of discount
 Allows firms to convert receivables into cash quickly
o Compensating Balances
 Some lenders require borrowers to keep 5 to 20% of outstanding loan
amount in a chequing account
 Increases effective cost of a loan as borrower doesn’t have full use of
amount borrowed

Commercial Paper

- Short term IOU sold by a company

- Attractive source of financing as large amounts of money can be raised at interest rates
that are usually 1 to 2 percent less than IR charged by banks

Sources of Long-Term Financing

Public Sale of Shares and Bonds

- Provide cash inflows for issuing firm and either a share in its ownership or a specified
rate of interest and repayment at a stated time
- Bond sales tend to be higher when interest rate is low
- IBankers purchase securities from issuer and then resells to investors
- Issuer pays a fee to the IBanker, called an underwriting discount

Private Placements

- Share/Bond issues offered to a small group of major investors such as pension funds and
insurance companies
- Most PP’s involve corporate debt issues
- Often cheaper for a company to sell a security privately than publicly, due to less
government regulation

Venture Capitalists
 - VC’s are business firms or groups of individuals that invest in new and growing firms in
exchange for an ownership share
- Typically raise money from wealthy individuals and institutional investors and invest
these funds in promising firms
- Can also provide management consulting advice

Private Equity Funds

- Investment companies that raise funds from wealthy individuals and institutional
investors
- These funds are then invested in both public and privately held companies
- PEF’s invest in all types of businesses, including mature companies
- Sovereign Wealth Funds are owned by governments and make investments based on
best risk-return trade-off

Hedge Funds

- Private investment companies available only to qualified large investors

- Traditionally hedge funds did not make direct investment in companies, instead
preferring to purchase existing shares and bond issues

Merger: A transaction where two or more firms combine into one company

Acquisition: One firm buys the assets of another firm and assumes that firm’s obligations

- In a merger, seller is often referred to as a target

Tender Offer: A proposal made by a firm to the target firm’s shareholders specifying a price and
the form of payment

Synergy: The benefits produced by a merger or acquisition

Leveraged Buyouts (LBO’s): Transactions where public shareholders are bought out and the
firm reverts to private status

Divestiture: The sale of assets by a firm, either through a selloff or spinoff

- Selloff
o When assets are sold by one firm to another
- Spinoff
o When the assets sold form a new firm

Reasons why Firms Divest Assets

- Acquisitions do not work out as well as expected
- Firm makes strategic decision to focus on its core businesses