2. Financial Management
Chapter 18

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Learning Objectives
Identify three fundamental concepts that affect financial decisions and identify the primary responsibilities of a financial manager
Describe the budgeting process, three major budgeting challenges, and the four major types of budgets
Compare the advantages and disadvantages of debt and equity financing and explain the two major considerations in choosing from financing alternatives
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Learning Objectives
Identify the major categories of short-term debt financing
Identify the major categories of long-term debt financing
Describe the two options for equity financing and explain how companies prepare an initial public offering
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5. The Role of Financial Management
Planning for a firm’s money needs and managing the allocation and spending of funds
Risk/ Return Trade-Off
The balance of potential risks against potential rewards
Planning for a firm’s money needs and managing the allocation and spending of funds are the foundations of financial management, or finance. In most smaller companies, the owner is responsible for the firm’s financial decisions, whereas in larger operations, financial management is the responsibility of the finance department. This department, which includes the accounting function, reports to a vice president of finance or a chief financial officer (CFO).
Most financial decisions involve balancing potential risks against potential rewards, known as a risk/return trade-off. Generally speaking, the higher the perceived risk, the higher the potential reward, and vice versa. However, this situation doesn’t always hold true.
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Financial Management: Three Fundamental Concepts
Exhibit 18.1
Whether the owner of a small company or the chief financial officer (CFO) of a major corporation, a financial manager must grapple with these three fundamental concepts.
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7. Developing a Financial Plan
A document that outlines the funds needed for a certain period of time, along with the sources and intended uses of those funds
Strategic plan, company’s financial statements, external financial environment
Successful financial management starts with a financial plan, a document that outlines the funds a firm will need for a certain period of time, along with the sources and intended uses of those funds.
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Finding and Allocating Funds
Exhibit 18.2
Financial management involves finding suitable sources of funds and deciding on the most appropriate uses for those funds.
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9. Managing Accounts Receivable and Accounts Payable
Amounts that are currently owed to a firm
Accounts Payable
Amounts that a firm currently owes to other parties
Keeping an eye on accounts receivable—the money owed to a firm by its customers—is one way to manage cash flow effectively. The volume of receivables depends on a financial manager’s decisions regarding several issues: who qualifies for credit and who does not, how long customers are given to pay their bills, and how aggressive the firm is in collecting its debts.
The flip side of managing receivables is managing accounts payable—the bills that the company owes to its suppliers, lenders, and other parties. The objective is generally to postpone paying bills until the last moment, because doing so allows the firm to hold on to its cash, for as long as possible.
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Monitoring the Working Capital Accounts
Exhibit 18.3
The working capital accounts represent a firm’s cash on hand as well as economic value that can be converted to cash (inventory) or is expected from customers (accounts receivable), minus what it is scheduled to be paid out (accounts payable).
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The Budgeting Process
Budget
A planning and control tool that reflects expected revenues, operating expenses, and cash receipts and outlays
Financial Control
The process of analyzing and adjusting the basic financial plan to correct for deviations from forecasted events
In addition to developing a financial plan and monitoring cash flow, financial managers are responsible for developing a budget, a financial guide for a given period, usually the company’s fiscal year, or for the duration of a particular project.
After a budget has been developed, the finance manager compares actual results with projections to discover variances and recommends corrective action, a process known as financial control.
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Exhibit 18.4
Budgeting Challenges
Budgeting can be a tough challenge that requires difficult choices; here are three big issues manager usually face.
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The Budgeting Process
Hedging
Protecting against cost increases with contracts that allow a company to buy supplies in the future at designated prices
In some cases, companies can protect themselves against future price increases by hedging, arranging contracts that allow them to buy supplies in the future
at designated prices. The obvious risk of hedging against rising prices is that prices could instead drop, leaving a company paying more than it would have to otherwise.
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14. The Budgeting Process (cont.)
Zero-Based Budgeting
A budgeting approach in which each year starts from zero and must justify every item in the budget, rather than simply adjusting the previous year’s budget amounts
A more responsive approach is zero-based budgeting, in which each department starts from zero every year and must justify every item in the budget.7 This approach forces each department to show how the money it wants to spend will support the overall strategic plan. The downside to zero-based budgeting is the amount of time it takes.
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Types of Budgets
Start-Up Budget
A budget that identifies the money a new company will need to spend to launch operations
Operating Budget
A budget that identifies all sources of revenue and coordinates the spending of those funds throughout the coming year
Also known as the master budget
Before a new company starts business, the entrepreneurial team assembles a start-up budget, or launch budget, that identifies all the money it will need to “get off the ground.”
After a company gets through the start-up phase, the financial manager’s attention turns to the operating budget, sometimes known as the master budget, which identifies all sources of revenue and coordinates the spending of those funds throughout the coming year.
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16. Types of Budgets (cont.)
Capital Budget
A budget that outlines expenditures for real estate, new facilities, major equipment, and other capital investments
Capital Investments
Money paid to acquire something of permanent value in a business
A capital budget outlines expenditures for real estate, new facilities, major equipment, and other capital investments. For smaller capital purchases, a company might designate a certain percentage of its annual operating budget for capital items every year.
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17. Types of Budgets (cont.)
Project Budget
A budget that identifies the costs needed to accomplish a particular project
Another special type of budget that has to be coordinated with the operating budget is the project budget, which identifies the costs needed to accomplish a particular project, such as conducting the research and development of a new product or moving a company to a new office building.
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18. Financing Alternatives: Factors to Consider
Debt Financing
Arranging funding by borrowing money
Equity Financing
Arranging funding by selling ownership shares in the company, publicly or privately
The most fundamental decision a company faces regarding financing is whether it will obtain funds by debt financing, which is borrowing money, or by equity financing, which is selling ownership shares in the company.
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Length of Term
Short-Term Financing
Financing used to cover current expenses (generally repaid within a year)
Long-Term Financing
Financing used to cover long-term expenses such as assets (generally repaid over a period of more than one year)
Financing can be either short term or long term. Short-term financing is financing that will be repaid within one year, whereas long-term financing is financing that will be repaid in a period longer than one year. The primary purpose of short-term financing is to ensure that a company maintains its liquidity, or its ability to meet financial obligations (such as inventory payments) as they become due. By contrast, long-term financing is used to acquire long-term assets such as buildings and equipment or to fund expansion via any number of growth options.
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Interest Rates
Prime Interest Rate
The lowest rate of interest that banks charge for short-term loans to their most creditworthy customers
The prime interest rate (often called simply the prime) is the lowest interest rate offered on short-term bank loans to preferred borrowers. The prime changes irregularly and, at times, quite frequently.
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Opportunity Cost
Leverage
The technique of increasing the rate of return on an investment by financing it with borrowed funds
Capital Structure
A firm’s mix of debt and equity financing
A company might be better off investing its excess cash in external opportunities, such as stocks of other companies, and borrowing money to finance its own growth. Doing so makes sense as long as the company can earn a greater rate of return (the percentage increase in the value of an investment) on those investments than the rate of interest paid on borrowed money. This concept is called leverage because the loan acts like a lever: It magnifies the power of the borrower to generate profits (see Exhibit 18.6).
However, leverage works both ways: Borrowing may magnify your losses as well as your gains. Because most companies require some degree of external financing from time to time, the issue is not so much whether to use outside money; rather, it’s a question of how much should be raised, by what means, and when. The answers to such questions determine the firm’s capital structure, the total mix of debt and equity it uses to meet its short- and long-term needs.
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22. Financing Alternatives: Short-Term Debt
Trade Credit
Credit obtained by a purchaser directly from a supplier
Secured Loans
Loans backed up with assets that the lender can claim in case of default, such as a piece of property
Trade credit, often called open-account purchasing, occurs when suppliers provide goods and services to their customers without requiring immediate payment. Such transactions create the accounts receivable defined on page 397.
Secured loans are those backed by something of value, known as collateral, that may be seized by the lender in the event that the borrower fails to repay the loan. Common types of collateral include property, equipment, accounts receivable, inventories, and securities.
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23. Financing Alternatives: Short-Term Debt (cont.)
Unsecured Loans
Loans that require a good credit rating but no collateral
Compensating Balance
The portion of an unsecured loan that is kept on deposit at a lending institution to protect the lender and increase the lender’s return
Unsecured loans are ones that require no collateral. Instead, the lender relies on the general credit record and the earning power of the borrower.
Most lenders insist that the borrower maintain some minimum amount of money on deposit at the bank—a compensating balance—while the loan is outstanding.
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24. Financing Alternatives: Short-Term Debt (cont.)
Line of Credit
An arrangement in which a financial institution makes money available for use at any time after the loan has been approved
Commercial Paper
Short-term promissory notes, or contractual agreements, to repay a borrowed amount by a specified time with a specified interest rate
A common example of an unsecured loan is a line of credit, which is an agreed-on maximum amount of money a bank is willing to lend a business. Once a line of credit has been established, the business may obtain unsecured loans for any amount up to that limit. The key advantage of a line of credit over a regular loan is that interest (or at least full interest) is usually not charged on the untapped amount.
When businesses need a sizable amount of money for a short period of time, they can issue commercial paper—short-term promissory notes, or contractual agreements, to repay a borrowed amount by a specified time with a specified interest rate. Commercial paper is usually sold only by major corporations with strong credit ratings, in denominations of $100,000 or more and with maturities of up to 270 days (the maximum allowed by the Securities and Exchange Commission [SEC] without a formal registration process)
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Leases
Lease
An agreement to use an asset in exchange for regular payment; similar to renting
Rather than borrow money to purchase an asset, a firm may enter into a lease, under which the owner of an asset (the lessor) allows another party (the lessee) to use it in exchange for regular payments. (Leasing is similar to renting; a key difference is that leases fix the terms of the agreement for a specific amount of time.)
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Corporate Bonds
Bonds
A method of funding in which the issuer borrows from an investor and provides a written promise to make regular interest payments and repay the borrowed amount in the future
When a company needs to borrow a large sum of money, it may not be able to get the entire amount from a single source. Under such circumstances, it may try to borrow from many individual investors by issuing bonds—certificates that obligate the company to repay a certain sum, plus interest, to the bondholder on a specific date. (Note that although bondholders buy bonds, they are acting as lenders.)
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Corporate Bonds
Secured Bonds
Bonds backed by specific assets that will be given to bondholders if the borrowed amount is not repaid
Debentures
Corporate bonds backed only by the reputation of the issuer
Secured bonds, like secured loans, are backed by company-owned property (such as airplanes or plant equipment) that passes to the bondholders if the issuer does not repay the amount borrowed. Mortgage bonds, one type of secured bond, are backed by real property owned by the issuing corporation. Debentures are unsecured bonds, backed only by the corporation’s promise to pay. Because debentures are riskier than other types of bonds, the companies that issue them must pay higher interest rates to attract buyers.
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28. Corporate Bonds (cont.)
Convertible Bonds
Corporate bonds that can be exchanged at the owner’s discretion into common stock of the issuing company
Convertible bonds can be exchanged at the investor’s option for a certain number of shares of the corporation’s common stock. Because of this feature, convertible bonds generally pay lower interest rates.
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Private Equity
Private Equity
Ownership assets that aren’t publicly traded; includes venture capital
Venture capital is a specialized form of funding known as private equity (ownership assets that aren’t publicly traded), and other forms of private equity can provide funding for companies that are beyond the start-up stage. For instance, the leveraged buyouts discussed in Chapter 5 are usually done with private equity funds.
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30. Public Stock Offerings
Preparing the IPO
Registering the IPO
Going public, offering shares of stock to the public through a stock market such as the New York Stock Exchange, can generate millions or even billions of dollars in funding. As you can read in the Behind the Scenes wrap-up starting on page 429, this is the financing path Visa chose, and its initial public offering (IPO) raised a record $19.6 billion
Selling the IPO
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31. Public Stock Offerings (cont.)
Underwriter
A specialized type of bank that buys the shares from the company preparing an IPO and sells them to investors
Prospectus
An SEC-required document that discloses required information about the company, its finances, and its plans for using the money it hopes to raise
THE END
Preparing an offering involves assembling a team of advisors that includes legal experts, a public accounting firm to serve as auditor, and an underwriter,
a specialized type of bank known as an investment bank that buys the shares from the company and sells them to investors.
Before a company can sell shares to the public in the United States, it must first register with the SEC. This process includes submitting a prospectus, which discloses required information about the company, its finances, and its plans for using the money it hopes to raise. The SEC reviews the information and typically requests modifications and additional information to make the filing conform with all applicable regulations.
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