1. CHAPTER 18 Financial Management McGraw-Hill/Irwin
Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.

2. LEARNING OBJECTIVES
Explain the role and responsibilities of financial managers.
Outline the financial planning process, and explain the three key budgets in the financial plan.
Explain why firms need operating funds.
Identify and describe different sources of short-term financing.
Identify and describe different sources of long-term financing.
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3. SABRINA SIMMONS Gap
Simmons earned her bachelor’s in finance at UC- Berkeley and her MBA at UCLA.
Joined Gap as treasurer in 2001, balanced the books, and eliminated the reliance on risky investments.
Encourages Gap to not be afraid to create new brands, even after failure.
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4. NAME that COMPANY
This company spends over $6 billion a year on research to develop new products even though it may take as long as ten years before the products are approved and introduced to the market. Since long-term funding is very critical in our business, high-level managers are very involved in the finance decisions.
Name that company!
Companies: Pfizer
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5. WHAT’S FINANCE?
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Finance -- The function in a business that acquires funds for a firm and manages them within the firm.
Finance activities include:
Preparing budgets
Creating cash flow analyses
Planning for expenditures
See Learning Objective 1: Explain the responsibilities of financial managers.
The finance function is responsible for managing a scarce resource - capital.
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6. FINANCIAL MANAGEMENT
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Financial Management -- The job of managing a firm’s resources to meet its goals and objectives.
See Learning Objective 1: Explain the responsibilities of financial managers.
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7. FINANCIAL MANAGERS
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Financial Managers -- Examine financial data and recommend strategies for improving financial performance.
Financial managers are responsible for:
Paying company bills
Collecting payments
Staying abreast of market changes
Assuring accounting accuracy
See Learning Objective 1: Explain the responsibilities of financial managers.
This slide provides insight into the role of financial management.
One point that is critical to communicate to students, is that financial managers must understand accounting (and in fact many of them have backgrounds in accounting), but they are not accountants within the company. They are decision-makers and managers in the truest sense of the word.
You might want to work through each of the functions of the financial manager and make certain students see exactly what’s involved in such a job. Students often perk up when they hear that quite often next to the company CEO, the chief financial officer (CFO) is the highest paid person within an organization. It’s also a good time with this slide to reinforce exactly how the relationship between accounting and finance works. If students can catch on early, this chapter is easy for them to navigate.
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8. WHO’S WHO in FINANCE CFO -- Chief Financial Officer
CFP -- Certified Financial Planner
CFA -- Chartered Financial Analyst
Comptroller -- Chief Accounting Officer
See Learning Objective 1: Explain the responsibilities of financial managers.
This slide presents the positions a person in finance might hold.
Help students understand that there are a variety of positions a person in finance might strive to obtain.
Ask students: What are some of the functions/responsibilities of each of these positions? How are these positions alike? How might they be different?
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9. FOUR SIGNS YOU NEED a CFO
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You do not have information on key items like cash flow, working capital, or forecasts.
No one is carefully watching and analyzing your expenses.
You are not aware of regulatory changes that could affect your business.
You are unable to generate financial reports.
See Learning Objective 1: Explain the responsibilities of financial managers.
Source: Karen Stern, St. Louis Small Business Monthly, January 2014.
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10. WHAT FINANCIAL MANAGERS DO
LO 18-1
See Learning Objective 1: Explain the responsibilities of financial managers.
This slide (based on Figure 18.1) gives the student a broad overview of what responsibilities financial managers have within a corporation. The CFOs responsibilities are rooted in the functions of “control” and “treasury.”
The control function has its basis in the budgeting process:
The budget represents the quantification of the goals and missions of the company as manifested by the resources required to attain those goals.
The budget becomes the scorecard by which the company as a whole is measured.
3. The other area of responsibility for CFOs is the treasury function.
Procurement of financial resources available to the company.
Ongoing communication with financial sources, investors, and debt holders who must be kept apprised of the firm’s financial performance.
Allocation of resources within the context of the company budget.
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11. WHAT WORRIES FINANCIAL MANAGERS
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Consumer demand for their firm’s products
Credit markets and interest rates
Financial regulations from the government
Volatility of the dollar
Foreign competition
Environmental regulations
See Learning Objective 1: Explain the responsibilities of financial managers.
This slide highlights the things that worry financial managers.
Financial managers are required to wear many hats in the organization. While specific responsibilities of a CFO will vary between large and small companies, and public and closely held companies, the principles of control and treasury responsibilities transgress all boundaries.
The number of issues that financial managers face is one reason why they are so well compensated.
Source: CFO Magazine, accessed November 2014.
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12. WHY DO FIRMS FAIL FINANCIALLY?
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Undercapitalization
Poor control over cash flow
Inadequate expense control
See Learning Objective 1: Explain the responsibilities of financial managers.
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13. TOP FINANCIAL CONCERNS of COMPANY CFOs - MACRO
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Consumer demand
Federal-government policies
Price pressure from competitors
Credit markets/interest rates
Global financial instability
See Learning Objective 1: Explain the responsibilities of financial managers.
This slide highlights the top concerns of company CFOs in the macro economy.
The Chief Financial Officers of companies must concern themselves with a multitude of issues.
Source: CFO Magazine, accessed November 2014.
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14. TOP FINANCIAL CONCERNS of COMPANY CFOs - MICRO
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Ability to maintain margins
Ability to forecast results
Maintaining morale/productivity
Cost of healthcare
Working-capital management
See Learning Objective 1: Explain the responsibilities of financial managers.
This slide highlights the top concerns of company CFOs within their own businesses.
The Chief Financial Officers of companies must concern themselves with a multitude of issues.
Source: CFO Magazine, accessed November 2014.
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15. FINANCIAL PLANNING
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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 Objective 2: Outline the financial planning process and explain the three key budgets in the financial plan.
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16. FINANCIAL FORECASTING
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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 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 Objective 2: Outline the financial planning process and explain the three key budgets in the financial plan.
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17. BUDGETING
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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 Objective 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.
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18. TYPES of BUDGETS
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Capital 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.
Operating (Master) Budget -- Ties together all the firm’s other budgets and summarizes its proposed financial activities.
See Learning Objective 2: Outline the financial planning process and explain the three key budgets in the financial plan.
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19. FINANCIAL PLANNING LO 18-2
See Learning Objective 2: Outline the financial planning process and explain the three key budgets in the financial plan.
This slide is based on Figure 18.2.
The capital and cash budgets are part of the operating (master) budget.
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20. ESTABLISHING FINANCIAL CONTROL
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Financial Control -- A process in which a firm periodically compares its actual revenues, costs and expenses with its budget.
See Learning Objective 2: Outline the financial planning process and explain the three key budgets in the financial plan.
Financial controls also help reveal which specific accounts, departments and people are varying from the financial plan.
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21. FACTORS USED in ASSESSING FINANCIAL CONTROL
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Is the firm meeting its short-term financial commitments?
Is the firm producing adequate operating profits on its assets?
How is the firm financing its assets?
Are the firms owners receiving an acceptable return on their investment?
See Learning Objective 2: Outline the financial planning process and explain the three key budgets in the financial plan.
This slide highlights the factors used in assessing financial control.
Financial control is used in conjunction with the firm’s budget to ensure the organization is meeting its commitments and goals.
Ask students: Why is it important for the CFO to maintain financial control?
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22. TEST PREP
Name three finance functions important to the firm’s overall operations and performance.
What three primary financial problems cause firms to fail?
How do short-term and long-term financial forecasts differ?
What’s the purpose of preparing budgets? Can you identify three different types of budgets?
The three finance functions are: financial planning, budgeting, and the establishment of financial control.
The three primary financial problems causing firms to fail are: undercapitalization, poor control of cash flow, and inadequate expense control.
Short-term forecasts attempt to project revenue, costs, and expenses for a period of one year or less, while long-term forecasts are for a period greater than one year.
A budget sets forth management’s expectations for revenues and becomes the organization’s primary guide for the financial operations as well as expected financial needs. The three types of budgets are: capital, cash, and operating.
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23. KEY NEEDS for OPERATIONAL FUNDS in a FIRM
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Managing day-by-day needs of the business
Controlling credit operations
Acquiring needed inventory
Making capital expenditures
See Learning Objective 3: Explain why firms need operating funds.
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24. HOW SMALL BUSINESSES CAN IMPROVE CASH FLOW
Be more aggressive in collecting accounts receivable.
Offer customers discounts for paying early.
Take advantage of special payment terms from vendors.
Raise prices.
Use credit cards discriminately.
See Learning Objective 3: Explain why firms need operating funds.
The slide lists methods small businesses use to improve cash flow.
Lack of cash flow can impact a business of any size and may lead to the business shutting its doors.
It is critical that students understand cash is king for a business of any size.
Source: American Express Small Business Monitor.
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25. GOOD FINANCE or BAD MEDICINE?
You are a new hospital administrator at a small hospital that, like many others, is experiencing financial problems.
You suggest discontinuing the hospital’s large stockpile of drugs and shift to ordering them just when they are needed.
Some like the idea, but the doctors claim you are sacrificing patients’ well-being for cash. What do you do? What could be the result of your decision?
See Learning Objective 2: Outline the financial planning process and explain the three key budgets in the financial plan.
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26. USING ALTERNATIVE SOURCES of FUNDS
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Debt Financing -- The funds raised through various forms of borrowing that must be repaid.
Equity Financing -- The funds raised from within the firm from operations or through the sale of ownership in the firm (such as stock).
See Learning Objective 3: Explain why firms need operating funds.
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27. SHORT and LONG-TERM FINANCING
Short-Term Financing -- Funds needed for a year or less.
Long-Term Financing -- Funds needed for more than a year.
See Learning Objective 3: Explain why firms need operating funds.
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28. WHY FIRMS NEED FINANCING
LO 18-3
See Learning Objective 3: Explain why firms need operating funds.
It is important for management to understand that they need capital for a variety of short-term and long-term situations.
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29. TEST PREP Money has time value. What does this mean?
Why is accounts receivable a financial concern of the firm?
What’s the primary reason an organization spends a good deal of its available funds on inventory and capital expenditures?
What’s the difference between debt and equity financing?
Time value of money means money can grow over time through interest earned.
Providing credit to customers is often necessary to keep current customers happy and to attract new customers. The problem with selling on credit is that as much as 25 percent of the firm’s assets could be tied up in accounts receivable. This forces the business to use it own funds to pay for goods or services sold to customers who bought on credit.
To attract customers a firm must purchase inventory as well as invest in tangible long-term assets such as land, buildings, and equipment, or intangible assets such as patents, trademarks, and copyrights.
The primary difference between debt and equity financing is that debt must be repaid at maturity, while there is no obligation to repay equity financing. Interest must be paid on debt while the company is under no obligation to issue dividends on equity financing. The interest paid is tax deductible while dividends are not. Finally, debt holders do not have the right to vote on company matters as equity holders do.
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30. TYPES of SHORT-TERM FINANCING
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Trade Credit -- The practice of buying goods or services now and paying for them later.
Businesses often get terms such as 2/10 net 30 when receiving trade credit.
Promissory Note -- A written contract agreeing to pay a supplier a specific sum of money at a definite time.
See Learning Objective 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.
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31. TYPES of SHORT-TERM FINANCING
LO 18-4
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 Objective 4: Identify and describe different sources of short-term financing.
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32. DIFFICULTY of OBTAINING SHORT-TERM FINANCING
LO 18-4
Banks generally prefer to lend short- term money to larger, more established businesses.
See Learning Objective 4: Identify and describe different sources of short-term financing.
The recent financial crisis has made it difficult for even promising and well-organized businesses to get loans.
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33. THREADING the FINANCIAL NEEDLE
Started thredUP with classmates while studying for his MBA at Harvard.
Launched the company in as a way to buy and sell adult clothing.
Transitioned into children’s clothes.
The company continues to attract huge investments to further improve the site.
See Learning Objective 4: Identify and describe different sources of short-term financing.
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34. DIFFERENT FORMS of SHORT-TERM LOANS
Commercial banks offer short-term loans like:
Secured Loans -- Backed by collateral.
Unsecured Loans -- Don’t require collateral from the borrower.
Line of Credit -- A given amount of money the bank will provide so long as the funds are available.
Revolving Credit Agreement -- A line of credit that’s guaranteed but comes with a fee.
See Learning Objective 4: Identify and describe different sources of short-term financing.
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35. FACTORING
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Factoring -- The process of selling accounts receivable for cash.
Factors charge more than banks, but many small businesses don’t qualify for loans.
See Learning Objective 4: Identify and describe different sources of short-term financing.
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36. COMMERCIAL PAPER
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Commercial Paper -- Unsecured promissory notes in amounts of $100,000+ that come due in 270 days or less.
Since commercial paper is unsecured, only financially stable firms are able to sell it.
See Learning Objective 4: Identify and describe different sources of short-term financing.
The commercial paper market is an important source of funding for financially stable companies.
During the financial crisis which started in 2008, this important market completely shut down, forcing the Federal Reserve to step in and assist many companies with their short-term financing by purchasing their commercial paper.
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37. Photo Creditf: Robert Scoble
CREDIT CARDS
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Rates for small businesses grew almost 30% after The Credit Card Responsibility Accountability and Disclosure Act was passed.
Credit cards are convenient but costly for a small business.
See Learning Objective 4: Identify and describe different sources of short-term financing.
Photo Creditf: Robert Scoble
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38. WAYS to RAISE START-UP CAPITAL
LO 18-4
Seek out a microloan from a microlender
Use asset-based lending or factoring
Turn to the web and seek out peer-to-peer lending
Research local banks
Sweet-talk vendors you want to do business with
See Learning Objective 4: Identify and describe different sources of short-term financing.
This slide profiles some of the unique methods businesses can use to raise capital.
Trade credit and factoring are two of the oldest methods of raising capital. To start a discussion with students ask the advantages and disadvantages of using each of these methods.
Peer-to-peer lending involves individuals loaning money to other individuals or businesses thus bypassing traditional lending outlets.
For more information on this new method use loan statistics from
Sources: St. Louis Small Business Monthly, January 2014 and Entrepreneur, accessed November 2014.
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39. HOW COMPANIES FAIL to RAISE CAPITAL
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There is no formalized business plan to show need.
The company does not know how much to request from a lender.
Poor credit.
Management is unrealistic about growth.
See Learning Objective 4: Identify and describe different sources of short-term financing.
Source: St. Louis Small Business Monthly, January 2014.
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40. TEST PREP What does an invoice containing the terms 2/10, net 30 mean?
What is the difference between trade credit and a line of credit?
What is the key difference between a secured and an unsecured loan?
What is factoring? What are some of the considerations factors consider in establishing their discount rate?
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.
Trade credit is buying goods and services now and paying for them later, while a line of credit is a given amount of unsecured short term funds a bank will lend a business, provided the funds are readily available.
A secured loan requires collateral, while an unsecured loan doesn’t not.
Factoring is the process of sell accounts receivable for cash. Things to consider in establishing the discount rate are: age of the accounts receivable, the nature of the business, and the condition of the economy.
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41. SETTING LONG-TERM FINANCING OBJECTIVES
Three questions of financial managers in setting long- term financing objectives:
What are the organization’s long-term goals and objectives?
What funds do we need to achieve the firm’s long-term goals and objectives?
What sources of long-term funding (capital) are available, and which will best fit our needs?
See Learning Objective 5: Identify and describe different sources of long-term financing.
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42. The FIVE “C”s of CREDIT The character of the borrow.
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The character of the borrow.
The borrower’s capacity to repay the loan.
The capital being invested in the business by the borrower.
The conditions of the economy and the firm’s industry.
The collateral the borrower has available to secure the loan.
See Learning Objective 5: Identify and describe different sources of long-term financing.
This slide highlights the 5 “C”s of credit that lenders use to make decisions.
It is essential that lenders make good decisions when deciding whether or not to loan capital to potential borrowers.
Go through each of the C’s and have students evaluate how important each one is. Are they equally important for the lenders to consider? Why or why not?
Ask students: Can you think of any other things the lenders should consider before loaning money? (Note: these do not have to be words that start with C.)
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43. ARE THEY HEROS or HUSTLERS?
Rich nations place their excess incomes into sovereign wealth funds (SWFs).
SWFs are hailed as heroes when billions are invested in distressed companies. However, some grow concerned with the presence of foreign governments.
Much of that concern seems to be unfounded because of investigations by the U.S. government.
See Learning Objective 5: Identify and describe different sources of long-term financing.
In 2012, Middle Eastern nations spent less on foreign investments than they had in years. Instead, they put their money into improving infrastructure, education and salaries for workers in their own nations.
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44. USING 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 Objective 5: Identify and describe different sources of long-term financing.
Lenders may also require certain restrictions to force the firm to act responsibly.
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45. USING DEBT FINANCING by ISSUING BONDS
LO 18-5
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 Objective 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.
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46. SECURING EQUITY FINANCING
LO 18-5
A company can secure equity financing by:
Selling shares of stock in the company.
Earning profits and using the retained earnings as reinvestments in the firm.
Attracting Venture Capital -- Money that is invested in new or emerging companies that some investors believe have great profit potential.
See Learning Objective 5: Identify and describe different sources of long-term financing.
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47. WANT to ATTRACT a VENTURE CAPITALIST?
LO 18-5
Can the company grow?
Will we get our money back and more?
Will it be worth our money and effort?
See Learning Objective 5: Identify and describe different sources of long-term financing.
This slide shows how venture capitalists assess the many pitches they receive all year.
Venture capitalists want to ensure that not only will they get their money back, but that they will also earn more than their investment.
Why is a question like “Will it be worth our money and effort?” important to venture capitalists? (VCs want to make sure there is a large return on their investment so they can make money and continue investing in other companies.)
Source: Entrepreneur, accessed November 2014.
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48. DIFFERENCES BETWEEN DEBT and EQUITY FINANCING
LO 18-5
See Learning Objective 5: Identify and describe different sources of long-term financing.
This slide is based on Figure 18.6.
Financial managers must evaluate the benefits of issuing debt or equity and then weigh those benefits with the drawbacks.
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49. USING LEVERAGE for FUNDING NEEDS
LO 18-5
Leverage -- Raising funds through borrowing to increase the firm’s rate of return.
Cost of Capital -- The rate of return a company must earn in order to meet the demands of its lenders and expectations of equity holders.
See Learning Objective 5: Identify and describe different sources of long-term financing.
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50. USING DEBT vs. EQUITY FINANCING
LO 18-5
See Learning Objective 5: Identify and describe different sources of long-term financing.
Financial managers must evaluate the benefits of issuing debt or equity and then weigh those benefits with the drawbacks.
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51. LESSONS LEARNED from the RECENT FINANCIAL CRISIS
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The recent financial crisis was the worst fall since the Great Depression.
Led to the passage of sweeping financial reform.
Government is increasing involvement and intervention.
See Learning Objective 5: Identify and describe different sources of long-term financing.
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52. TEST PREP
What are the two major forms of debt financing available to a firm?
How does debt financing differ from equity financing?
What are the three major forms of equity financing available to a firm?
What is leverage, and why do firms choose to use it?
A company could issue and sell bonds or they could borrow from financial institutions and individuals.
The primary difference between debt financing and equity financing is that debt must be repaid at maturity while there is no obligation to repay equity financing. Interest must be paid on debt, while the company is under no obligation to issue dividends on equity financing. The interest paid is tax deductible, while dividends are not. Finally, debt holders do not have the right to vote on company matters, while equity holders usually do have voting rights.
A business can obtain equity financing from the sale of company stock, from retained earnings, or from venture capital firms.
Leverage is borrowing funds to invest in expansion, major asset purchases, or research and development. Firms use leverage in an effort to increase the firm’s profit.
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