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  1. 1. Chapter 18 Financial ManagementMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. ChapterEighteen LEARNING GOALS 1. Explain the role and responsibilities of financial managers. 2. Outline the financial planning process, and explain the three key budgets in the financial plan. 3. Explain why firms need operating funds. 4. Identify and describe different sources of short- term financing. 5. Identify and describe different sources of long-term financing. 18-2
  3. 3. Profile CAROL TOMÉ Home Depot • Tomé worked her way up to Chief Financial Officer (CFO) at Home Depot in 2001. • Home Depot was in a store building frenzy; adding more than 100 locations a year through 2005. • Tomé was at the center of tech transition by overseeing the distribution of $350 million in spending. 18-3
  4. 4. ChapterEighteen NAME that COMPANY At one time this company was the largest automobile maker in the world. Due to severe financial problems in 2009, the company came very close to extinction. A $7 billion government-backed loan and an additional $43 billion government investment in the company helped it survive. It is now attempting a comeback as a much smaller company. Name that company! 18-4
  5. 5. The Role ofFinance andFinancialManagers WHAT’S FINANCE? LG1 • 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 18-5
  6. 6. The Role ofFinance andFinancialManagers FINANCIAL MANAGEMENT LG1 • Financial Management -- The job of managing a firm’s resources to meet its goals and objectives. 18-6
  7. 7. The Role ofFinance andFinancialManagers FINANCIAL MANAGERS LG1 • 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 18-7
  8. 8. FinancialPlanning WHO’S WHO in FINANCE LG2 • CFO -- Chief Financial Officer • CFP -- Certified Financial Planner • CFA -- Chartered Financial Analyst • Comptroller -- Chief Accounting Officer 18-8
  9. 9. The Role ofFinance andFinancialManagers WHAT FINANCIAL LG1 MANAGERS DO 18-9
  10. 10. The Role ofFinance andFinancial WHAT WORRIES FINANCIALManagers LG1 MANAGERS • 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 Source: CFO Magazine,, accessed July 2011. 18-10
  11. 11. The Value ofUnderstandingFinance WHY DO FIRMS LG1 FAIL FINANCIALLY? 1) Undercapitalization 2) Poor control over cash flow 3) Inadequate expense control 18-11
  12. 12. The Value ofUnderstandingFinance TOP FINANCIAL CONCERNS LG1 of COMPANY CFOs - MACRO • Consumer demand • Federal-government policies • Price pressure from competitors • Credit markets/interest rates • Global financial instability Source: CFO Magazine, July/August 2010. 18-12
  13. 13. The Value ofUnderstandingFinance TOP FINANCIAL CONCERNS LG1 of COMPANY CFOs - MICRO • Ability to maintain margins • Ability to forecast results • Maintaining morale/productivity • Cost of healthcare • Working-capital management Source: CFO Magazine, July/August 2010. 18-13
  14. 14. FinancialPlanning FINANCIAL PLANNING LG2 • Financial planning involves analyzing short-term and long-term money flows to and from the company. • Three key steps of financial planning: 1. 18-14
  15. 15. ForecastingFinancialNeeds FINANCIAL FORECASTING LG2 • 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. 18-15
  16. 16. Working withthe BudgetProcess BUDGETING LG2 • 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. 18-16
  17. 17. Working withthe BudgetProcess TYPES of BUDGETS LG2 • 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. 18-17
  18. 18. Working withthe BudgetProcess FINANICAL PLANNING LG2 18-18
  19. 19. EstablishingFinancialControl ESTABLISHING LG2 FINANCIAL CONTROL • Financial Control -- A process in which a firm periodically compares its actual revenues, costs and expenses with its budget. 18-19
  20. 20. EstablishingFinancial FACTORS USED in ASSESSINGControl LG2 FINANCIAL CONTROL • 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? 18-20
  21. 21. ProgressAssessment PROGRESS ASSESSMENT • 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? 18-21
  22. 22. The Need forOperatingFunds KEY NEEDS for OPERATIONAL LG3 FUNDS in a FIRM • Managing day-by-day needs of the business • Controlling credit operations • Acquiring needed inventory • Making capital expenditures 18-22
  23. 23. FINANCIAL ORDER or FINANCIAL MARTIAL LAW? (Legal Briefcase)• In Michigan, half of the state’s communities are in financial distress.• Local Government and School District Fiscal Accountability Act allows cities, towns, and school districts to be taken over by state- appointed emergency financial managers (EFMs) selected by the Governor.• Indiana is considering similar legislation. New York and other states’ boards have been given similar power. 18-23
  24. 24. The Need forOperating HOW SMALL BUSINESSESFunds LG3 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. Source: American Express Small Business Monitor. 18-24
  25. 25. GOOD FINANCE or BAD MEDICINE? (Making Ethical Decisions)• You’re 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’re sacrificing patients’ well-being for cash. What do you do? What could be the result of your decision? 18-25
  26. 26. AlternativeSources ofFunds USING ALTERNATIVE LG3 SOURCES of FUNDS • 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). 18-26
  27. 27. AlternativeSources ofFunds SHORT and LONG-TERM LG3 FINANCING • Short-Term Financing -- Funds needed for a year or less. • Long-Term Financing -- Funds needed for more than a year. 18-27
  28. 28. AlternativeSources ofFunds WHY FIRMS NEED FINANCING LG3 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 18-28
  29. 29. ProgressAssessment PROGRESS ASSESSMENT • 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? 18-29
  30. 30. Trade Credit TYPES of LG4 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. • Promissory Note -- A written contract agreeing to pay a supplier a specific sum of money at a definite time. 18-30
  31. 31. Family andFriends TYPES of LG4 SHORT-TERM FINANCING • Many small firms obtain short-term financing from friends and family. • If asking for help from family or friends, it’s important both parties: 1) Agree to specific loan terms 2) Put the agreement in writing 3) Arrange for repayment the same way they would for a bank loan 18-31
  32. 32. CommercialBanks DIFFICULTY of OBTAINING LG4 SHORT-TERM FINANCING • 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. 18-32
  33. 33. EXPLORING the FINANCING UNIVERSE (Spotlight on Small Business)• Peer-to-peer lending sites like Lending Club match small businesses with lenders and receive a fee for their services.• Lendio claims to have developed a technology that matches business owners with the right type of business loan and lender.• Lendio also offers services such as a business plan makeover and website design for a fee. 18-33
  34. 34. DifferentForms ofShort-Term DIFFERENT FORMS ofLoans LG4 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. 18-34
  35. 35. FactoringAccountsReceivable FACTORING LG4 • Factoring -- The process of selling accounts receivable for cash. • Factors charge more than banks, but many small businesses don’t qualify for loans. 18-35
  36. 36. CommercialPaper COMMERCIAL PAPER LG4 • 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. 18-36
  37. 37. Credit Cards CREDIT CARDS LG4 • Rates for small businesses grew almost 30% after the Credit Card Responsibility Accountability and Disclosure Act was passed. Photo Courtesy of: Robert Scoble • 18-37
  38. 38. Credit Cards WAYS to RAISE LG4 START-UP CAPITAL • 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 Source: Entrepreneur,, accessed July 2011. 18-38
  39. 39. ProgressAssessment PROGRESS ASSESSMENT • What does an invoice containing the terms 2/10, net 30 mean? • What’s the difference between trade credit and a line of credit? • What’s the key difference between a secured and an unsecured loan? • What’s factoring? What are some of the considerations factors consider in establishing their discount rate? 18-39
  40. 40. ObtainingLong-TermFinancing SETTING LONG-TERM LG5 FINANCING OBJECTIVES • Three questions of financial managers in setting long- term financing objectives: 1. What are the organization’s long-term goals and objectives? 2. What funds do we need to achieve the firm’s long-term goals and objectives? 3. What sources of long-term funding (capital) are available, and which will best fit our needs? 18-40
  41. 41. ObtainingLong-TermFinancing The FIVE “C”s of CREDIT LG5 1. The character of the borrow. 2. The borrower’s capacity to repay the loan. 3. The capital being invested in the business by the borrower. 4. The conditions of the economy and the firm’s industry. 5. The collateral the borrower has available to secure the loan. 18-41
  42. 42. DebtFinancing USING LONG-TERM LG5 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. 18-42
  43. 43. DebtFinancing USING DEBT FINANCING LG5 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. 18-43
  44. 44. EquityFinancing SECURING EQUITY FINANCING LG5 • 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. 18-44
  45. 45. EquityFinancing WANT to ATTRACT a LG5 VENTURE CAPITALIST? 1. Can the company grow? 2. Will we get our money back and more? 3. Will it be worth our money and effort? Source: Entrepreneur, February 2011. 18-45
  46. 46. ComparingDebt andEquity DIFFERENCES BETWEENFinancing LG5 DEBT and EQUITY FINANCING Types of Financing Conditions Debt Equity None. Unless special Common stock Management influence conditions have been holders have voting agreed on. rights. Debt has a maturity Stock has no maturity Repayment date. date. The firm isn’t legally Yearly obligations Payment of interest. liable to pay dividends. Interest is tax Dividends are not tax Tax benefits deductible. deductible. 18-46
  47. 47. ComparingDebt andEquity USING LEVERAGE forFinancing LG5 FUNDING NEEDS • 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. 18-47
  48. 48. Lessons Fromthe FinancialCrisis LESSONS of the LG5 FINANCIAL CRISIS • 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. 18-48
  49. 49. ProgressAssessment PROGRESS ASSESSMENT • 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? 18-49