Chapter Nineteen

Mastering Financial
Management

Copyright © Cengage Learning. All rights reserved

19 | 1
 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.
Copyright © Cengage Learning. All rights reserved 19 | 2
 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

Copyright © Cengage Learning. All rights reserved 19 | 3

 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

Copyright © Cengage Learning. All rights reserved 19 | 4

 Cash Flow for a Manufacturing Business

Copyright © Cengage Learning. All rights reserved 19 | 5

 Comparison of Short- and Long-Term
Financing

Copyright © Cengage Learning. All rights reserved 19 | 6

 The Need for Financial Management
• Risk-return ratio
– Based on the principle that a high-risk decision should
generate higher financial returns for a business and
more conservative decisions often generate lesser
returns
• 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
– Credit customers pay on time and delinquencies are
reduced
– Bills are paid promptly
– Taxes are paid in a timely manner
– Excess cash is invested in interest-bearing securities

Copyright © Cengage Learning. All rights reserved 19 | 7

 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

Copyright © Cengage Learning. All rights reserved 19 | 8

 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

Copyright © Cengage Learning. All rights reserved 19 | 9

 The Three Steps of Financial Planning

Copyright © Cengage Learning. All rights reserved 19 | 10

 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

Copyright © Cengage Learning. All rights reserved 19 | 11

 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

Copyright © Cengage Learning. All rights reserved 19 | 12

 Sales Budget for Stars and
Stripes Clothing

Copyright © Cengage Learning. All rights reserved 19 | 13

 Cash Budget for Stars and
Stripes Clothing

Copyright © Cengage Learning. All rights reserved 19 | 14

 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

Copyright © Cengage Learning. All rights reserved 19 | 15

 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

Copyright © Cengage Learning. All rights reserved 19 | 16

 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
Copyright © Cengage Learning. All rights reserved 19 | 17
 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

Copyright © Cengage Learning. All rights reserved 19 | 18

 Average Prime Interest Rate

Source: Federal Reserve Bank website, www.federalreserve.gov, accessed October 17, 2008.

Copyright © Cengage Learning. All rights reserved 19 | 19

 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

Copyright © Cengage Learning. All rights reserved 19 | 20

 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

Copyright © Cengage Learning. All rights reserved 19 | 21

 Comparison of Short-Term Financing
Methods

Copyright © Cengage Learning. All rights reserved 19 | 22

 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

Copyright © Cengage Learning. All rights reserved 19 | 23

 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
Copyright © Cengage Learning. All rights reserved 19 | 24
 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

Copyright © Cengage Learning. All rights reserved 19 | 25

 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
• Private Placement
– Stocks and other corporate securities are sold directly to insurance
companies, pension funds, or large institutional investors

Copyright © Cengage Learning. All rights reserved 19 | 26

 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

Copyright © Cengage Learning. All rights reserved 19 | 27

 Effects of Additional Capital

Copyright © Cengage Learning. All rights reserved 19 | 28

 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

Copyright © Cengage Learning. All rights reserved 19 | 29

 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
Copyright © Cengage Learning. All rights reserved 19 | 30
 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
Copyright © Cengage Learning. All rights reserved 19 | 31
 Comparison of Long-Term Financing
Methods

Copyright © Cengage Learning. All rights reserved 19 | 32