Chapter 18

Financial
Management

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter
Eighteen
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
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
Chapter
Eighteen
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
The Role of
Finance and
Financial
Managers
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
The Role of
Finance and
Financial
Managers
FINANCIAL MANAGEMENT
LG1

• Financial Management --
The job of managing a firm’s
resources to meet its goals
and objectives.

18-6
The Role of
Finance and
Financial
Managers
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
Financial
Planning
WHO’S WHO in FINANCE
LG2

• CFO -- Chief Financial

Officer
• CFP -- Certified Financial
Planner
• CFA -- Chartered Financial
Analyst
• Comptroller -- Chief
Accounting Officer

18-8
The Role of
Finance and
Financial WHAT FINANCIAL
Managers
LG1 MANAGERS DO

18-9
The Role of
Finance and
Financial WHAT WORRIES FINANCIAL
Managers
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, www.cfo.com, accessed July 2011.
18-10
The Value of
Understanding
Finance WHY DO FIRMS
LG1 FAIL FINANCIALLY?

1) Undercapitalization

2) Poor control over

cash flow

3) Inadequate expense
control

18-11
The Value of
Understanding
Finance
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
The Value of
Understanding
Finance
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
Financial
Planning 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. Forecasting the firm’s short-term and long-term
financial needs.
2. Developing budgets to meet those needs.
3. Establishing financial controls to see if the company is
achieving its goals.

18-14
Forecasting
Financial
Needs 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
Working with
the Budget
Process 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
Working with
the Budget
Process 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
Working with
the Budget
Process FINANICAL PLANNING
LG2

18-18
Establishing
Financial
Control
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
Establishing
Financial FACTORS USED in ASSESSING
Control
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
Progress
Assessment 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
The Need for
Operating
Funds
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
 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
The Need for
Operating HOW SMALL BUSINESSES
Funds
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
 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
Alternative
Sources of
Funds
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
Alternative
Sources of
Funds
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
Alternative
Sources of
Funds 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
Progress
Assessment 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
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
Family and
Friends 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
Commercial
Banks 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
 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
Different
Forms of
Short-Term DIFFERENT FORMS of
Loans
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
Factoring
Accounts
Receivable
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
Commercial
Paper 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
Credit Cards
CREDIT CARDS
LG4

• 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.

Photo Courtesy of: Robert Scoble

18-37
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, www.entrepreneur.com, accessed July 2011.

18-38
Progress
Assessment 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
Obtaining
Long-Term
Financing
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
Obtaining
Long-Term
Financing 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
Debt
Financing 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
Debt
Financing 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
Equity
Financing 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
Equity
Financing 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
Comparing
Debt and
Equity DIFFERENCES BETWEEN
Financing
LG5 DEBT and EQUITY FINANCING
Types of Financing

Conditions Debt Equity

None. Unless special Common stock
Management
conditions have been holders have voting
influence
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
Comparing
Debt and
Equity USING LEVERAGE for
Financing
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
Lessons From
the Financial
Crisis
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
Progress
Assessment 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