Chapter 16 mastering financial managementpridehugheskapoor,

Chapter 16
Mastering Financial Management
Pride/Hughes/Kapoor, Foundations of Business, 6th Edition. ©
2019 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
Learning Objectives
16-1 Understand why financial management is important in
today’s competitive economy.
16-2 Identify a firm’s short- and long-term financial needs.
16-3 Summarize the process of planning for financial
management.
16-4 Identify the services provided by banks and financial
institutions for their business customers.
16-5 Describe the advantages and disadvantages of different
methods of short-term debt financing.
16-6 Evaluate the advantages and disadvantages of equity
financing.
16-7 Evaluate the advantages and disadvantages of long-term
debt financing.
The Need for Financial Management
Financial management – all the activities concerned with
obtaining money and using it effectively
Proper financial management must ensure that:
Funds are available when needed both now and in the future,

obtained at the lowest possible cost, and used as efficiently as
possible.
Financing priorities are established in line with organizational
goals and objectives.
Spending is planned and controlled.
A firm’s credit customers pay their bills on time, and the
number of past due accounts is reduced.
Bills are paid promptly to protect the firm’s credit rating and its
ability to borrow money.
The funds required for paying the firm’s taxes are available
when needed to meet tax deadlines.
Excess cash is invested in certificates of deposit (CDs),
government securities, or conservative, marketable securities.
Careers in Finance
Typical job titles in finance include:
Chief financial officer
Vice-president of finance
Bank officer
Consumer credit officer
Financial analyst
Financial planner
Loan officer
Insurance analyst
Investment account executive
In addition to honesty, managers and employees in the finance
area must:

TABLE 16-1 Comparison of Short- and Long-Term Financing
Whether a business seeks short- or long-term financing depends
on what the money will be used for.
Short-Term Financing NeedsCash-flow problemsSpeculative
productionCurrent inventory needsMonthly expensesShort-term
promotional needsUnexpected emergencies
Long-Term Financing NeedsBusiness start-up costsMergers and
acquisitionsNew product developmentLong-term marketing
activitiesReplacement of equipmentExpansion of facilities
Short-Term 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
Speculative production – the time lag between the actual
production of goods and when the goods are sold
Long-Term Financing
Long-term financing – money that will be used for longer than
one year

The Risk–Return Ratio
Risk–return ratio – a ratio based on the principle that a high-
risk decision should generate higher financial returns for a
business and more conservative decisions often generate lower
returns
Planning—The Basis of Sound Financial Management
Financial plan – a plan for obtaining and using the money
needed to implement an organization’s goals and objectives
FIGURE 16-3 The Three Steps of Financial Planning
Developing the Financial Plan
Budget – a financial statement that projects income,

expenditures, or both over a specified future period
Cash budget – a financial statement that estimates cash receipts
and cash expenditures over a specified period
Most firms use one of two approaches to budgeting.
Traditional approach – a budgeting approach in which each new
budget is based on the dollar amounts contained in the budget
for the preceding year, the amounts are modified to reflect any
revised goals, and managers are required to justify only new
expenditures
Zero-base budgeting – a budgeting approach in which every
expense in every budget must be justified
To develop a plan for long-term financing needs, managers
often construct a capital budget.
Capital budget – a financial statement that estimates a firm’s
expenditures for major assets and its long-term financing needs
FIGURE 16-4 Cash Budget for Stars and Stripes Clothing
Traditional Banking Services for Business Clients (1 of 2)
Savings and Checking Accounts
A business with excess cash it is willing to leave on deposit
with a bank for a set period of time can earn a higher rate of
interest.
To do so, the business firm buys a certificate of deposit.
Certificate of deposit (C D) – a document stating that the bank

will pay the depositor a guaranteed interest rate on money left
on deposit for a specified period of time
Traditional Banking Services for Business Clients (2 of 2)
Business Loans
Short-term business loans:
Must be repaid within one year or less
To help ensure that short-term money will be available when
needed, many firms establish a line of credit.
Line of credit – a loan that is approved before the money is
actually needed
Revolving credit agreement – a guaranteed line of credit
Long-term business loans:
Are repaid over a period of years
Most lenders require some type of collateral for long-term
loans.
Collateral – real estate or property pledged as security for a
loan
Credit and Debit Card Transactions
A recent Gallup poll found that:
Three out of four Americans (76 percent) have at least one
credit card.
On average, Americans have 3.4 credit cards.
Half of Americans (48 percent) are carrying credit card debt
from one month to the next because they don’t pay their entire

credit card debt each month.
By depositing charge slips into a bank or other financial
institution, the merchant can convert credit-card sales into cash.
In return for processing the merchant’s credit-card transactions,
the financial institution charges a fee that generally ranges
between 1.5 and 4 percent.
Debit card – a card that electronically subtracts the amount of a
customer’s purchase from her or his bank account at the moment
the purchase is made
Electronic Banking Services
Electronic funds transfer (EFT) system – a means of performing
financial transactions through a computer terminal
Four EFT applications:
International Banking Services
Letter of credit – a legal document issued by a bank or other

financial institution guaranteeing to pay a seller a stated amount
for a specified period of time
Certain conditions, such as delivery of the merchandise, may be
specified before payment is made.
Banker’s acceptance – a written order for a bank to pay a third
party a stated amount of money on a specific date
No conditions are specified; it is simply an order to pay without
any strings attached.
Both a letter of credit and a banker’s acceptance are popular
methods of paying for import and export transactions.
Sources of Unsecured Short-Term Financing (1 of 3)
Short-term debt financing is usually easier to obtain than long-
term debt financing for three reasons:
Most lenders do not require collateral for short-term financing.
Unsecured financing – financing that is not backed by collateral
Trade Credit
Trade credit – a type of short-term financing extended by a
seller who does not require immediate payment after delivery of
merchandise

It is the most popular form of short-term financing, because
most manufacturers and wholesalers do not charge interest for
trade credit.
Promissory Notes Issued to Suppliers
Promissory note – a written pledge by a borrower to pay a
certain sum of money to a creditor at a specified future date
Promissory notes usually require the borrower to pay interest.
A promissory note offers two important advantages to the firm
extending the credit.
Unsecured Bank Loans
Prime interest rate – the lowest rate charged by a bank for a
short-term loan
Generally is reserved for large corporations with excellent
credit ratings
As a condition of an unsecured loan, a bank may require that a
compensating balance be kept on deposit at the bank and that
every commercial borrower clean up (pay off completely) its
short-term loans at least once a year and not use short-term
borrowing again for a period of 30 to 60 days.
Commercial Paper
Commercial paper – a short-term promissory note issued by a
large corporation
The interest rate a corporation pays when it sells commercial
paper is tied to its credit rating and its ability to repay the
commercial paper.

Sources of Secured Short-Term Financing
Loans Secured by Inventory
Finished goods, raw materials, and work-in-process inventories
may be pledged as collateral for short-term loans.
Loans Secured by Receivables
Accounts receivable – amounts owed to a firm by its customers
A firm can pledge its accounts receivable as collateral to obtain
short-term financing.
Factoring Accounts Receivable
Factor – a firm that specializes in buying other firms’ accounts
receivable
The factor buys the accounts receivable for less than their face
value; however, it collects the full face value dollar amount
when each account is due.
The factor’s profit is the difference between the face value of
the accounts receivable and the amount the factor has paid for
them.
TABLE 16-2 Comparison of Short-Term Financing Methods
(1 of 2)Type of FinancingCostRepayment PeriodBusinesses
That May Use ItCommentsTrade creditLow, if any30–60

daysAll businesses with good creditUsually no finance
chargePromissory note issued to suppliersModerateOne year or
lessAll businessesUsually unsecured but requires legal
documentUnsecured bank loanModerateOne year or lessAll
businessesPromissory note is required and compensating
balance may be required
TABLE 16-2 Comparison of Short-Term Financing Methods
(2 of 2)Type of FinancingCostRepayment PeriodBusinesses
That May Use ItCommentsCommercial paperModerate270 days
or lessLarge corporations with high credit ratingsUsually
available only to large firmsSecured loanHighOne year or
lessFirms with questionable credit ratingsInventory or accounts
receivable often used as collateralFactoringHighNoneFir ms that
have large numbers of credit customersAccounts receivable sold
to a factor
Selling Stock (1 of 3)
Initial Public Offering and the Primary Market
Initial public offering (I P O) – occurs when a corporation sells
common stock to the general public for the first time
When a corporation uses an I P O to raise capital, the stock is
sold in the primary market.
Primary market – a market in which an investor purchases
financial securities (via an investment bank) directly from the
issuer of those securities

Investment banking firm – an organization that assists
corporations in raising funds, usually by helping to sell new
issues of stocks, bonds, or other investment securities
Initial Public Offering and the Primary Market (cont.)
Advantages of selling stock: Equity finance are low for two
reasons.
The Secondary Market
Secondary market – a market for existing financial securities
that are traded between investors
Usually, secondary-market transactions are completed through
a(n):
Common Stock
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
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
Retained Earnings
Retained earnings – the portion of a corporation’s profits not
distributed to stockholders
Venture Capital, Angel Investors, and Private Placements
Venture capital – money invested in small (and sometimes
struggling) firms that have the potential to become very
successful
Angel investor – an investor who provides financial backing for
small business startups or entrepreneurs
Private placement – occurs when stock and other corporate
securities are sold directly to insurance companies, pension
funds, large institutional investors, or mutual funds
Sources of Long-Term Debt Financing
Financial leverage – the use of borrowed funds to increase the
return on owners’ equity
The principle of financial leverage works as long as a firm’s
earnings are larger than the interest charged for the borrowed

money.
For a small business, long-term debt financing is generally
limited to loans, whereas large corporations have the additional
option of issuing corporate bonds.
Long-Term Loans
Term-Loan Agreements
Term-loan agreement – a promissory note that requires a
borrower to repay a loan in monthly, quarterly, semiannual, or
annual installments
The interest rate and repayment terms for term loans often are
based on factors such as:
The lender usually requires some type of collateral.
Lenders may also require that borrowers maintain a minimum
amount of working capital.
Corporate Bonds (1 of 3)
Corporate bond – a corporation’s written pledge that it will
repay a specified amount of money with interest
Interest rates for corporate bonds vary with the financial health
of the company issuing the bond.
Specific factors that increase or decrease the interest rate that a
corporation must pay when it issues bonds include:

Most corporate bonds are registered bonds.
Registered bond – a bond registered in the owner’s name by the
issuing company
Maturity date – the date on which a corporation is to repay
borrowed money
FIGURE 16-7 The Risk–Return Ratio for Corporate Bond
Investors
Types of Bonds
Debenture bond – a bond backed only by the reputation of the
issuing corporation
Mortgage bond – a corporate 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

Repayment Provisions for Corporate Bonds
Bond indenture – a legal document that details all the
conditions relating to a bond issue
A corporation may use one of three methods to ensure it has
sufficient funds available to redeem a bond issue.
Trustee – an individual or an independent firm that acts as a
bond owner’s representative
TABLE 16-4 Comparison of Long-Term Financing Methods (1
of 2)Type of FinancingRepaymentRepayment
PeriodCost/Dividends/InterestBusinesses That May Use
ItEquityCommon stockNoNoneHigh initial cost; low ongoing
costs because dividends not requiredAll corporations that sell
stock to investorsPreferred stockNoNoneDividends not required
but must be paid before common stockholders receive any
dividendsLarge corporations that have an established investor
base of common stockholders
TABLE 16-4 Comparison of Long-Term Financing Methods (2

of 2)Type of FinancingRepaymentRepayment
PeriodCost/Dividends/InterestBusinesses That May Use
ItDebtLong-term loanYesUsually 3–7 yearsInterest rates
between 3 and 12 percent depending on economic conditions,
the financial stability of the company requesting the loan, and
the amount of the loanAll firms that can meet the lender’s
repayment and collateral requirementsCorporate
bondYesUsually 1–30 yearsInterest rates between 3.5 and 10
percent depending on the financial stability of the company
issuing the bonds and economic conditionsLarge corporations
that are financially healthy
Chapter 15
Using Management and Accounting Information
Learning Objectives
15-1 Examine how information can reduce risk when making a
decision.
15-2 Discuss management’s information requirements.
15-3 Outline the five functions of an information system.
15-4 Explain why accurate accounting information and audited
financial statements are important.

15-5 Read and interpret a balance sheet.
15-6 Read and interpret an income statement.
15-7 Describe business activities that affect a firm’s cash flow.
15-8 Summarize how managers evaluate the financial health of
a business.
Information and Risk
To improve the decision-making process, the information used
by individuals and business firms must be relevant.
Using relevant information results in better decisions.
Relevant information → Better intelligence and knowledge →
Better decisions
For businesses, better intelligence and knowledge that lead to
better decisions are especially important because they can
provide a competitive edge over competitors and improve a
firm’s profits.
FIGURE 15-1 The Relationship Between Information and Risk
The Difference Between Data and Information

Data – numerical or verbal descriptions that usually result from
some sort of measurement
Information – data presented in a form that is useful for a
specific purpose
Knowledge Management (1 of 2)
Database – a single collection of data and information stored in
one place that can be used by people throughout an organization
to make decisions
Knowledge management (K M) – a firm’s procedures for
generating, using, and sharing important data and information
Knowledge Management (2 of 2)
Making Smart Decisions
Decision-support system (D S S) – a type of software program
that provides relevant data and information to help a firm’s
employees make decisions
Expert system – a type of computer program that uses artificial
intelligence to imitate a human’s ability to think
Business Application Software
A number of business software applications can improve both
employee decision making and productivity.

TABLE 15-1 Current Business Application Software Used to
Improve ProductivityWord processingUsers can prepare and edit
written documents and store them in the computer or on a
memory device.Desktop publishingUsers can combine text and
graphics in professional reports, newsletters, and
pamphlets.AccountingUsers can record routine financial
transactions and prepare financial reports at the end of the
accounting period.Database managementUsers can
electronically store large amounts of data and transform the data
into information.GraphicsUsers can display and print pictures,
drawings, charts, and diagrams.SpreadsheetsUsers can organize
numerical data into a grid of rows and columns.
What Is a Management Information System?
Management information system (M I S) – a system that
provides managers and employees with the information they
need to perform their jobs as effectively as possible
The purpose of an MIS is to distribute timely and useful
information from both internal and external sources to the
managers and employees who need it.
FIGURE 15-2 Management Information System (M I3S)

A Firm’s Information Requirements (1 of 2)
Many firms are organized into five areas of management:
A Firm’s Information Requirements (2 of 2)
Managers in each of these areas need specific information in
order to make decisions.
Financial managers must ensure that the firm’s managers and
employees, lenders and suppliers, stockholders and potential
investors, and government agencies have the information they
need to measure the financial health of the firm.
Operations managers are concerned with present and future
sales levels, current inventory levels of work in process and
finished goods, and the availability and cost of the resources
required to produce goods and services.
Marketing managers need to have detailed information about a
firm’s products and services and those offered by competitors.
Human resources managers must be aware of anything that
pertains to a firm’s employees.
Administrative managers are responsible for the overall
management of the organization.

FIGURE 15-3 Five Management Information System Functions
Why Accounting Information Is Important
Accounting – the process of systematically collecting,
analyzing, and reporting financial information
Not only can accounting information be used to answer
questions about what has happened in the past, it can also be
used to help make decisions about the future.
To improve the accuracy of a firm’s accounting information and
its financial statements, businesses rely on audits conducted by
accountants employed by public accounting firms.
Why Audited Financial Statements Are Important
Audit – an examination of a company’s financial statements and
the accounting practices that produced them
The purpose of an audit is to make sure that a firm’s financial
statements have been prepared in accordance with generally
accepted accounting principles.
Generally accepted accounting principles (G A A P s) – an
accepted set of guidelines and practices for U.S. companies

reporting financial information and for the accounting
profession
Accounting Fraud, Ethical Behavior, and Reform
Accounting problems at many companies have forced many
investors, lenders and suppliers, and government regulators to
question the motives behind fraudulent and unethical accounting
practices.
Unfortunately, the ones hurt when companies report inaccurate
or misleading accounting information often are not the high-
paid corporate executives; rather, it’s the employees, who lose
their jobs and the money they invested in the company’s
retirement program if the company files for bankruptcy, and the
investors, lenders, and suppliers, who experience a loss due to
their investments in the company based on fraudulent
accounting information.
To help ensure that corporate financial information is accurate
and to prevent accounting scandals, Congress enacted the
Sarbanes-Oxley Act.
Different Types of Accounting
Accounting is usually broken down into two broad categories:
1.
2.

Additional special areas of accounting include:
Careers in Accounting
Accountants generally are classified as either:
Certified public accountant (C P A) – an individual who has met
state requirements and experience and has passed a rigorous
accounting examination
The Accounting Equation (1 of 2)
Accounting equation – the basis for the accounting process:
= +
-

-
-
The Accounting Equation (2 of 2)
To use the accounting equation, a firm’s accountants record the
firm’s day-to-day financial transactions using the double-entry
bookkeeping system.
Double-entry bookkeeping system – a system in which each
financial transaction is recorded as two separate accounting
entries to maintain the balance shown in the accounting
equation
At the end of a specific accounting period, all of the financial
transactions are summarized in the firm’s financial statements
and included in the firm’s annual report.
Annual report – a report distributed to stockholders and other
interested parties that describes the firm’s operating activities
and its financial condition
The Balance Sheet
Balance sheet (or statement of financial position) – a summary
of the dollar amounts of a firm’s assets, liabilities, and owners’
equity accounts at the end of a specific accounting period
The balance sheet must demonstrate that assets are equal to
liabilities plus owners’ equity, and the accounting equation is

still in balance.
FIGURE 15-5 Personal Balance Sheet
FIGURE 15-6 Business Balance Sheet
Assets (1 of 3)
On a balance sheet, assets are listed in order from the most
liquid to the least liquid.
Liquidity – the ease with which an asset can be converted into
cash
Current Assets
Current assets – assets that can be converted quickly into cash
or that will be used in one year or less

Assets (2 of 3)
Current Assets (continued)
Order of current assets from most liquid to least liquid:
Assets (3 of 3)
Fixed Assets
Fixed assets – assets that will be held or used for a period
longer than one year
Examples:
Depreciation – the process of apportioning the cost of a fixed
asset over the period during which it will be used
Intangible Assets
Intangible assets – assets that do not exist physically but that
have a value based on the rights or privileges they confer on a
firm
Examples:

Liabilities and Owners’ Equity (1 of 2)
Current Liabilities
Current liabilities – debts that will be repaid in one year or less
Balance sheet Includes:
Organizing e-Business Resources
Long-Term Liabilities
Long-term liabilities – debts that need not be repaid for at least
one year
Owners’ or Stockholders’ Equity
For a sole proprietorship or partnership, the owners’ equity is
shown as the difference between assets and liabilities.
For a corporation, the owners’ equity usually is referred to as
stockholders’ equity.
The dollar amount reported on the balance sheet is the total
value of stock plus retained earnings that have accumulated to
date.
Retained earnings – the portion of a business’s profits not
distributed to stockholders

The Income Statement
Income statement – a summary of a firm’s revenues and
expenses during a specified accounting period
The difference between income and expenses is referred to as:
Profit or loss (for a business)
Cash surplus or cash deficit (for an individual)
For a business:
– – = Net income
FIGURE 15-7 Personal Income Statement
FIGURE 15-8 Business Income Statement
Revenues
Revenues – the dollar amounts earned by a firm from selling
goods, providing services, or performing business activities
Gross sales − Sales deductions = Net sales
Gross sales – the total dollar amount of all goods and services

sold during the accounting period
Deductions:
Net sales – the actual dollar amounts received by a firm for the
goods and services it has sold after adjustment for returns,
allowances, and discounts
Cost of Goods Sold
Cost of goods sold – the dollar amount equal to beginning
inventory plus net purchases less ending inventory
Cost of goods sold = Beginning inventory + Net purchases –
Ending inventory
Gross profit – a firm’s net sales less the cost of goods sold
Gross profit = Net sales – Cost of goods sold
Operating Expenses
Operating expenses – all business costs other than the cost of
goods sold
Total operating expenses generally are divided into two
categories:

Net Income
Net income – occurs when revenues exceed expenses
Net loss – occurs when expenses exceed revenues
The Statement of Cash Flows (1 of 2)
Statement of cash flows – a statement that illustrates how the
company’s operating, investing, and financing activities affect
cash during an accounting period
FIGURE 15-9 Statement of Cash Flows
The Statement of Cash Flows (2 of 2)
Three different activities of a statement of cash flows; Explain
briefly:

The totals of all three activities are added to the beginning cash
balance to determine the ending cash balance.
Financial Ratios (1 of 3)
Financial ratio – a number that shows the relationship between
two elements of a firm’s financial statements
Measuring a Firm’s Ability to Earn Profits
Return on sales (or profit margin) – a financial ratio calculated
by dividing net income after taxes by net sales
Example for Northeast Art Supply:
The return on sales indicates how effectively the firm is
transforming sales into profits.
A higher return is better than a low one.
A low return on sales can be increased by reducing expenses
and increasing sales.
Measuring a Firm’s Ability to Pay Its Debts

Current ratio – a financial ratio computed by dividing current
assets by current liabilities
A high current ratio indicates that a firm can pay its current
liabilities.
A low current ratio can be improved by repaying current
liabilities, by reducing dividend payments to stockholders to
increase the firm’s cash balance, or by obtaining additional cash
from investors.
Measuring How Well a Firm Manages Its Inventory
Inventory turnover – a financial ratio calculated by dividing the
cost of goods sold in one year by the average value of the
inventory
Average value of the inventory:
(Beginning inventory + Ending inventory) ÷ 2
The average inventory turnover for all firms is about 9 times per
year, but turnover rates vary widely from industry to industry.
The quickest way to improve inventory turnover is to order
merchandise in smaller quantities at more frequent intervals.

Chapter 16 mastering financial managementpridehugheskapoor,

Chapter 16 mastering financial managementpridehugheskapoor,

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