The Goals and Functions of Financial Management

What is Finance? Art and Science of raising and transferring funds/managing money Science that describes the management, creation and study of money, banking, credit, investments, assets and liabilities.

WHAT IS FINANCIAL MANAGEMENT? Financial management or business finance is concerned with managing an entity’s money Functions: Allocate funds to current and fixed assets Obtain the best mix of financing alternatives Develop an appropriate dividend policy within the context of the firm’s objectives a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits.

Relationship between Finance, Economics and Accounting Economics provides structure for decision making in many important areas Provides a broad picture of economic environment Accounting provides financial data in various forms Income statements Balance sheets Statement of cash flows Finance links economic theory with the numbers of accounting

The Goals of Financial Management “Earn the highest possible profit for the firm” Also known as Profit Maximization Goal

The Goals of Financial Management  Profitability   Risk  Profitability   Risk Higher profits/returns are always associate with higher level of risk e.g. investing in stocks vs. savings accounts Stocks may be more profitable but are riskier Savings accounts are less profitable and less risky (or safer) Financial manager must choose appropriate combination of potential profit (return) and level of risk (safety)

The Goal of Financial Management Primary goal is to maximize the wealth* of the company’s shareholders (owners) by increasing the market value (price) of their shares *Wealth is a much broader concept than mere profit. Wealth creation concerns with both monetary and non-monetary issues (e.g. Goodwill, social responsibility, ethical issues)

Functions and Activities of Financial Management Functions involve: raising funds for the firm at minimal cost and acceptable risk investing those funds in company assets so as to earn an attractive return given acceptable risks Activities include: Working Capital Management short-term (S/T) financial decisions (<1 year) ex. managing cash and other current assets Capital Budgeting long-term (L/T) financial decisions (>1 year) ex. purchasing a new machine in the future Financing decisions (capital structure) how to raise money: loans? leases? shares? bonds?

Financial Management Chapter – 18

FINANCIAL PLANNING Financial planning involves analyzing short-term and long-term money flows to and from the company. Three key steps of financial planning: Forecasting the firm’s short-term and long-term financial needs. Developing budgets to meet those needs. Establishing financial controls to see if the company is achieving its goals. See Learning Goal 2: Outline the financial planning process and explain the three key budgets in the financial plan. 18-10

FINANCIAL FORECASTING Short-Term Forecast -- Predicts revenues, costs and expenses for a period of one year or less. Cash-Flow Forecast -- Predicts the cash inflows and outflows in future periods, usually for months or quarters. Long-Term Forecast -- Predicts revenues, costs, and expenses for a period longer than one year and sometimes as long as five or ten years. See Learning Goal 2: Outline the financial planning process and explain the three key budgets in the financial plan. 18-11

BUDGETING Budget -- Sets forth management’s expectations for revenues and allocates the use of specific resources throughout the firm. Budgets depend heavily on the balance sheet, income statement, statement of cash flows and short-term and long-term financial forecasts. The budget is the guide for financial operations and expected financial needs. See Learning Goal 2: Outline the financial planning process and explain the three key budgets in the financial plan. Budgeting is critical for the organization to control expenses and to understand revenue expectations. Think of a budget as a guidepost or a reference point for the organization’s managers. 18-12

3 Types of Budgets Capital Budget Cash Budget Highlights a firm’s spending plans for major asset purchases that often require large sums of money. Cash Budget Estimates cash inflows and outflows during a particular period like a month or quarter. See Learning Goal 2: Outline the financial planning process and explain the three key budgets in the financial plan. Operating (Master) Budget Ties together all the firm’s other budgets and summarizes its proposed financial activities. 18-13

WHY FIRMS NEED FINANCING Short-Term Funds Long-Term Funds Monthly expenses New-product development Unanticipated emergencies Replacement of capital equipment Cash flow problems Mergers or acquisitions Expansion of current inventory Expansion into new markets Temporary promotional programs New facilities See Learning Goal 3: Explain why firms need operating funds. This slide is based on Figure 18.5. It is important for management to understand that they need capital for a variety of short-term and long-term situations. 18-14

TYPES of SHORT-TERM FINANCING Trade Credit -- The practice of buying goods or services now and paying for them later. Businesses often get terms 2/10 net 30 when receiving trade credit. See Learning Goal 4: Identify and describe different sources of short-term financing. Trade credit is the most common form of financing. 2/10 net 30 means a firm can receive a 2% discount if the bill is paid within 10 days. If they choose not to take the discount, the net amount is due in 30 days. 18-15

Cont… Many small firms obtain short-term financing from friends and family. If asking for help from family or friends, it’s important both parties: Agree to specific loan terms Put the agreement in writing Arrange for repayment the same way they would for a bank loan See Learning Goal 4: Identify and describe different sources of short-term financing. 18-16

Cont.… Commercial Banks generally prefer to lend short-term money to larger, more established businesses. The recent financial crisis has made it difficult for even promising and well- organized businesses to get loans. See Learning Goal 4: Identify and describe different sources of short-term financing. 18-17

LONG-TERM DEBT FINANCING Long-term financing loans generally come due within 3 -7 years but may extend to 15 or 20 years. Term-Loan Agreement -- A promissory note that requires the borrower to repay the loan with interest in specified monthly or annual installments. A major advantage of debt financing is the interest the firm pays is tax deductible. See Learning Goal 5: Identify and describe different sources of long-term financing. Lenders may also require certain restrictions to force the firm to act responsibly. 18-18

DEBT FINANCING by ISSUING BONDS Indenture Terms -- The terms of agreement in a bond issue. Secured Bond -- A bond issued with some form of collateral (i.e. real estate). Unsecured (Debenture) Bond -- A bond backed only by the reputation of the issuing company. See Learning Goal 5: Identify and describe different sources of long-term financing. It is critical that students understand bonds are a form of debt issued by companies. The terms debt, bond, and loan are all four letter words and basically mean the same thing. Students should walk away from this discussion knowing that the government and private industry compete insofar as the sale of bonds to the investing public. The issue of investor security can easily be addressed here, as well as the differences in interest rates paid on specific bonds depending on the issuer. Students should understand that U.S. Government bonds are considered the safest investment in the bond market. There is a high probability that students will be familiar with U.S. Government Savings Bonds, and may in fact have received such a bond as a gift. They clearly need to understand the difference between such bonds and issues involving investments in corporate bonds. 18-19

Long Term Financing: Equity Financing By selling stock From retained earnings From venture capital See Learning Goal 5: Identify and describe different sources of long-term financing. 18-20

Understanding Accounting and Financial Information Chapter – 17

Income Statement An income statement is a financial statement that measures a company's financial performance over a specific accounting period. It shows the profit after deducting all the costs, expenses and taxes. It also summarizes all of the resources that have come into the firm (revenue) and all the resources that have left the firm, and the resulting net income.

Revenue It is an income, which is generated from sale of goods or services, or any other use of capital or assets, associated with the main operations of an organization before any costs or expenses are deducted. Also known as the monetary value of what a firm received for goods sold, services rendered, and other payments (e.g. rent received). Revenue and Sales are not the same thing.

Cost of Goods Sold(COGS) A measure of the cost of merchandise sold or cost of raw materials and supplies used for producing items for resale. Also known as Cost of Goods manufactured. Cost of goods sold includes the purchase price, any freight charges paid to transport goods and any costs associated with storing the goods.

Gross Profit (Gross Margin) It refers to how much a firm earned by buying (or making) and selling merchandise. When we subtract the costs of good sold from net sales, we get gross profit or gross margin. In a service firm, COGS might be absent, therefore, Gross profit is equal to net sales.

Operating Expenses Costs involved in operating a business It includes rent, utilities, supplies, insurance and salaries. Other Operating Expenses like Depreciation are much more complex. Depreciation is the systematic write-off of the cost of a tangible asset over its estimated useful life.

Net Profit or Loss After deducting all expenses, the firm’s net income before taxes can be determined. It is also known as net earnings or net profit. After allocating taxes, we get the net income (or net loss) the firm incurred from revenue minus sales returns, costs, expenses, and taxes over a period of time.

How to Compile Income Statement: Revenue - Cost of Goods Sold = Gross Profit (gross margin) - Operating Expenses = Net Income (before taxes) - Taxes = Net income/loss

Ratio Analysis The assessment of a firm’s financial condition, using calculations and financial ratios developed from the firm’s financial statements. Important because it gives an idea about the performance, situation of a particular organization. Some important Ratios: # Current Ratio # Debt Ratio # Earning per share # Return on sales # Return on equity # Inventory turnover

Ratio Analysis Current Ratio= Current asset/Current Liabilities Debt Ratio= Total liabilities/Owners’ equity EPS= Net income after Tax/Number of total shares Return on sales= Net income/Net sales Return on equity= Net income/Total owners’ equity Inventory turnover= Costs of goods sold/Average inventory