CHAPTER 18: FINANCIAL MANAGEMENT


CHAPTER 18: FINANCIAL MANAGEMENT
Layout of Chapter:
1.                  Finance
§         Tasks of Financial Manager
2.                  Planning for Cash Flow
§         Projecting month-by-month outward flow of funds
§         Projecting month-by-month flow of funds into the business
§         Comparing monthly inflows to monthly outflows
3.                  Generating Revenue from Excess Funds
4.                  Finding Efficient Source of Funds
§         Short-term financing: Debt capital
§         Long-term financing

1.                  FINANCE
The study of money within the firm; the business function responsible for finding funds, managing them and determining their best use.
Tasks of Financial Manager
Develop and follow a financial plan; including the following tasks:
  1. Project the month by month flow of funds out of the business.
  2. Project the month by month flow of funds into of the business.
  3. Compare the monthly inflows to the monthly outflows and 
·         If excess funds exist, find ways to generate revenue from these.
·         If there is a shortage of funds, adjust inflows or outflows if possible and/or look for other sources of funding.
  1. If other funding sources are needed, analyze the alternative sources of these funds to find the most efficient sources.
  2. Establish a system to monitor and evaluate the results of this process.
2.                  Planning for Cash Flow
Projecting Month-by-Month Outward Flow of Funds
Month-by-month outflow of funds represents the firm’s use of funds.
§         Cost of Daily Operations: the firm must plan to have sufficient cash reserves to pay rent, utilities, wages, interest expense, taxes, and the other short-term expenses of doing business.
§         Cost of Credit Services: most firms cannot do business on a strictly cash basis. Typically they provide customers with some form of credit to gain new customers and to encourage larger purchases. A firm that provides credit must maintain accounts receivable with date (the amount of money owed to a business from customers who purchased its goods or services).
§         Cost of Inventory: maintaining a sufficient inventory to satisfy your customers’ needs requires a considerable expenditure of funds. Inventory needs are further complicated by the fluctuations in demand. Different businesses have different inventory requirements.
Example: a grocery shop, to meet the extra demand before Eid, needs to maintain a sufficient inventory for a month or so before Eid. A producer of Mango juice would have to maintain a year-long inventory of Mangoes to ensure round-the-year supply of juice.
§         Purchase of Major Assets: major assets like land, buildings, equipments, vehicles have to be purchased during opening. These assets need to be periodically replaced and upgraded.
Example: a mobile phone company may need to purchase land in distant areas to set up communication towers to expand coverage.
§         Payment of Debt: most firms need to borrow money at some time or another. So the financial manager has to consider the payment of principal and interest on any outstanding debt.
§         Payment of Dividends: dividends are payments made to the shareholders of the firm as a form of earnings on their stocks. As a use of funds, the payment of dividend must be planned; while maintaining a reserve fund for future expansion.

Projecting Month By Month Flow of Funds into the Business
Month-by-month inflow of funds represents the firm’s sources of funds.
§         Revenue
§         Cash from credit sale when receivable is paid
§         Interest income expected from the investment of cash reserves and other excess funds.
Comparing Monthly Inflows with Monthly Outflows
3 possible outcomes-
1.      Two match perfectly; no action needs to be taken.
2.      Expected expenditures for the month can exceed expected income; additional funds needed to cover the shortfall.
3.      Expected income for the month can exceed expected expenditures; excess funds created.
3.                  Generating Revenues from Excess Funds
If expected income for the month exceeds expected expenditures, the firm must decide how to use the extra funds. Firms may decide to expand the business, or may use the funds to make highly liquid investments.
a.      Expansion
·         increase production capacity,
·         addition of new sales outlets, or
·         can acquire another firm etc.
b.      High–Liquidity Investments
·         Interest bearing checking account (low yield).
·         Following 3 types of securities can be easily converted into cash, giving the company high level of liquidity; these also have a relatively high rates of interest for a liquid investment:
1)      Treasury bill (maturity 3-6 months).
2)      Commercial Paper (short-term loan to major corporation with a high credit standing; maturity 3 days-9 months; riskier than T-bill).
3)      Certificates of Deposit (CDs; interest-bearing note issued by a commercial bank; 24 hours-10 years).
4.                  Finding Efficient Source of Funds
ü      For a Short-term need, short-term sources should be used.
ü      For a long-term need, long-term sources should be used.
Sources of Funds for Business
a)      Debt Capital: funds obtained through borrowing; with an interest.
b)      Equity Capital: funds provided in exchange for some ownership in the firm (Retained Earnings, additional contributions of by the owners, adding new partners, stock issues to public etc).
Table 18.1: Characteristics of debt and equity capital.
Debt Capital
Equity Capital
§         Repayment is designated.
§         No repayment needed.
§         Interest is an expense.
§         Dividends can be an expense; but are optional.
§         Interest paid may be deductible.
§         Dividends are not a deductible expense.
§         Can place claim against firm’s assets.
§         Has only secondary claim against assets.
§         Does not directly affect management power.
§         Can challenge corporate control.
§         Lenders may constrain management.
§         Shareholders typically will not block management.

Ö Short-Term Financing: Debt Capital
Short-term financing is used to obtain money to finance current operations, with repayment required within one year. Sources are –
a)      Trade credit: credit given by suppliers for the purchases the firm makes from these suppliers. (“2/10 net 30” – buyer takes 2% discount if payment is made within 10 days; if the discount is not taken, the full bill is due in 30 days.)
b)     Family and friends
c)      Commercial Banks:
  • Unsecured loan – a loan on the good credit of the borrower and requiring no collateral.
  • Secured loan – a loan backed with some form of collateral.
Ö Long-Term Financing
a)      Debt Capital: interest rates are generally higher than for short-term financing because the lender has to incur the loss for a longer period of time.
b)     Loans:
¤      3~7 years or 15~20 years
¤      Promissory Note – a legally binding promise of payment that spells out the terms of the loan agreement. (Term Loan Agreement)
c)      Bonds: an agreement between a firm and an investor with specific terms spelled out in an agreement called indenture. Bonds just like loans can be secured or unsecured.
¤      Secured Bond – backed by some form of collateral (i.e. specific property such as real estate, inventory or long-term assets that will pass to the bondholders should the company not live up to the terms of the agreement).
¤      Unsecured Bond (Debenture bond) – backed by the good name of the issuing company. Holders can make claims against the assets of a failed company only after the creditors with specific collateral have been paid.

More about Bonds ~
Junk Bond
*        A low grade bond that carries a very high risk
*        High risk because financially weak companies with no solid collateral, to fund internal expansion or corporate acquisitions and buyouts.
*        These bonds, with a very high interest rate have become popular in financing takeovers and leveraged buyouts (leverage is the use of long-term debt to raise needed cash).

Some Keywords ~
Indenture: The agreement for bond spelled out in detail is called indenture (periodic payments, principal payment on maturity etc).
Maturity: The point at which payment is due.
Serial Bonds: Mature at different intervals from the date of issue (to ease payment burden at a time).
Sinking Fund: The company set aside a certain sum of money each year to “sink” the bond debt (company can pay off a portion of the bonds each year or accumulate the funds until the bonds mature).

2 Types of Bonds are issued by a company:
§ Callable Bonds: company has the right to purchase back its bonds early. 
§ Convertible Bonds: paid off with stock in the company, which will be indicated in the indenture (the decision to accept stock or money left up to the individual bondholder).

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