FINANCIAL MANAGEMENT:The Role of the Financial Manager, Short-Term (Operating) Expenditures

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Introduction to Business MGT 211

Lesson 45

FINANCIAL MANAGEMENT

The job of the financial manager is to increase the firm's value by planning and controlling the

acquisition and dispersal of its financial assets. This task involves three key responsibilities:

cash-flow management (making sure the firm has enough available money to purchase the

materials it needs to produce goods and services), financial control (checking actual

performance against plans to ensure that desired financial results occur), and financial

planning (devising strategies for reaching future financial goals).

To finance short-term expenditures, firms rely on trade credit (credit extended by suppliers)

and loans. Secured loans require collateral (legal interest in assets that may include

inventories or accounts receivable). Unsecured loans may be in the form of lines of credit or

revolving credit agreements. Smaller firms may choose to factor accounts receivable (that is,

sell them to financial institutions).

Long-term sources of funds include debt financing, equity financing, and the use of preferred

stock. Debt financing uses long-term loans and corporate bonds (promises to pay holders

specified amounts by certain dates), both of which obligate the firm to pay regular interest.

Equity financing involves the use of owners' capital, either from the sale of common stock or

from retained earnings. Preferred stock is a hybrid source of funding that has some of the

features of both common stock and corporate bonds. Financial planners must choose the

proper mix of long-term funding. All-equity financing is the most conservative, least risky, and

most expensive strategy. All-debt financing is the most speculative option.

Businesses operate in an environment pervaded by risk. Speculative risks involve the prospect

of gain or loss. Pure risks involve only the prospect of loss or no loss. Firms manage their risks

by following some form of five-step process: identifying risks, measuring possible losses,

evaluating alternative techniques, implementing chosen techniques, and monitoring programs

on an ongoing basis. Four general methods for dealing with risk are risk avoidance, control,

retention, and transfer.

Insurance companies issue policies only for insurable risks--those that meet four criteria. First

the risk must be predictable in a statistical sense; the insurer must be able to use statistical

tools to forecast the likelihood of a loss. A loss must also pass the test of casualty, which

indicates the loss is accidental rather than intentional. Potential losses must also display un-

connectedness--they must be random and occur independently to other losses. Finally,

losses must be verifiable in terms of cause, time, place, and amount.

Liability insurance covers losses resulting from damage to people or property when the

insured is judged responsible. Property insurance covers losses to a firm's won buildings,

equipment, and financial assets. Life insurance pays benefits to the survivors of a policyholder

and has a cash value that can be claimed before the policyholder's death. Health insurance

covers losses resulting from medical and hospital expenses.

The Role of the Financial Manager

Corporate finance typically entails four responsibilities: determining a firm's long-term

investments, obtaining funds to pay for those investments, conducting the firm's everyday

financial

activities,

and

helping

manage

the

risks

the

firm

takes.

Responsibilities of the Financial Manager include planning and controlling the acquisition and

dispersal of a firm's financial resources.

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Introduction to Business MGT 211

Cash-Flow Management--management of cash inflows and outflows

to ensure adequate funds for purchases and the productive use of

excess funds.

ii.

Financial Control--process of checking actual performance against

plans to ensure that desired financial results occur.

iii.

Financial Planning--A financial plan shows the funds a firm will need

for a period of time, as well as the sources and uses of those funds. A

strategy for reaching some future financial position.

Why Do Businesses Need Funds?

It takes capital to run a business. There are numerous expenditures, which can be classified

into two broad categories.

Short-Term (Operating) Expenditures

Accounts Payable--unpaid bills plus wages and taxes due within the

upcoming year.

ii.

Accounts Receivable--funds due from customers who have bought on

credit. Credit Policy--rules governing a firm's extension of credit to

customers.

iii.

Inventories--materials and goods which are held by a company but

which will be sold within the year. The goal is to maintain an adequate

supply without incurring more costs than necessary for storage,

handling, insurance, and taxes. Three types of inventories-raw

materials inventory, work-in-process inventory, and finished-goods

inventory.

iv.

Working Capital--liquid current assets out of which a firm can pay

current debts. Calculated by adding inventories (raw materials, work-in-

process, and finished goods on hand) and accounts receivable (minus

accounts payable).

Long-Term (Capital) Expenditures

Companies need funds to cover long-term expenditures on fixed assets. Long-

term expenditures are not normally sold or converted into cash, require a very

large investment, and represent a binding commitment of company funds that

continues long into the future.

1. Sources of Short-Term Funds

a. Trade Credit--when a company buys products or supplies on credit from its

suppliers, postponing payment.

Open-Book Credit--form of trade credit in which sellers ship

merchandise on faith that payment will be forthcoming. Granting of

credit by one firm to another.

ii.

Promissory Note--form of trade credit in which sellers insist that

buyers sign a legally binding agreement before merchandise is shipped.

iii.

Trade Draft--form of trade credit in which a document stating the

promised date and amount of payment due, is attached to the

merchandise shipment by the seller.

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Introduction to Business MGT 211

Secured Short-Term Loans

Secured loans are those backed by some specific valuable item or items,

known as collateral, which may be seized by the lender, should the borrower

fail to repay the loan.

Inventory Loans use inventory as a collateral asset.

ii.

Accounts Receivable--accounts receivable are used as collateral,

known as pledging accounts receivable.

Factoring Accounts Receivable -- A firm can raise funds rapidly by factoring: selling the

firm's accounts receivable. They are sold at a discount.

Unsecured Short-Term Loans

Line of Credit--standing arrangement in which a lender agrees to

make available a specified amount of funds upon the borrower's

request.

ii.

Revolving Credit Agreement--arrangement in which a lender agrees

to make funds available on demand and on a continuing basis.

iii.

Commercial Paper--short-term securities, or notes, containing a

borrower's promise to pay. Matures in 270 days or less.

2. Sources of Long-Term Funds

a. Debt Financing--used to cover long-term expenses such as assets (generally

repaid in more than one year).

Long-Term Loans usually issued by commercial banks. Interest rates

fluctuate over time, and financial managers try to time their borrowing to

take advantage of drops in interest rates.

ii.

Corporate Bonds--Terms of a bond, including the amount to be paid,

the interest rate, and the maturity date differ from company to company

and from issue to issue. They are spelled out in the bond contract, or

bond indenture.

Equity Financing -- use of common stock and/or retained earnings to rise long-term funding.

Common Stock--selling ownership to raise money.

ii.

Retained Earnings--reinvesting profits in the company rather than

issue a dividend

iii.

Financial Burden on the Firm--a firm cannot deduct paid-out

dividends as business expenses but it can deduct the interest it pays on

bonds. However, debt is a legal obligation to repay regardless of

changes in economic conditions.

Hybrid Financing: Preferred Stock -- Preferred stock is a "hybrid" because it has some of

the features of both corporate bonds and common stocks. Provides a fixed dividend, is paid

dividends before common stock, and has no voting rights.

Choosing between Debt and Equity Financing -- relative mix of a firm's debt and equity

financing.

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Introduction to Business MGT 211

Indexes of Financial Risk--To help understand and measure the

amount of financial risk they face, financial managers rely on published

indexes for various investments.

The Risk-Return Relationship -- principle that, whereas safer investments tend to offer

lower returns, riskier investments tend to offer higher returns.

3. Financial Management for Small Business

Establishing Bank and Trade Credit -- obtaining a line of credit begins with finding a bank

that can-and will-support a small firm's financial needs. Liberal trade credit terms with

suppliers let small firms increase short-term funds and avoid additional borrowing from banks.

Long-Term Funding--with unproven repayment ability, start-up firms

can expect to pay higher interest rates than older firms. A Business

Plan detailing financial needs may help attain financing.

Venture Capital -- outside equity financing provided in return for part ownership of the

borrowing firm.

Planning for Cash-Flow Requirements -- Cash-flow planning is especially critical for small

businesses. By anticipating shortfalls, a financial manger can seek funds in advance and

minimize their cost.

4. Risk Management

a. Coping with Risk

Speculative Risk -- risk involving the possibility of gain or loss.

Pure Risk -- risk involving only the possibility of loss or no loss.

Risk Management--process of conserving the firm's earning power and assets

by reducing the threat of losses due to uncontrollable events.

Step 1: Identify Risks and Potential Losses

ii.

Step 2: Measure the Frequency and Severity of Losses and their Impact

iii.

Step 3: Evaluate Alternatives and Choose the Techniques That Will

Best Handle the Losses

Risk Avoidance--practice of avoiding risk by declining or ceasing to

participate in an activity.

Risk Control--practice of minimizing the frequency or severity of losses

from risky activities.

Risk Retention--practice of covering a firm's losses with its own funds.

Risk Transfer--practice of transferring a firm's risk to another firm. A

Premium is the fee paid by a policyholder for insurance coverage

iv.

Step 4: Implement the Risk-Management Program

Step 5: Monitor Results

The Contemporary Risk Management Program -- Virtually all business decisions involve risk

having financial consequences. The company's chief financial officer (CFO) has a major voice

in applying the risk management process.

Insurance as Risk Management

Companies may choose to transfer the risk of loss to an insurance company, which will agree

to compensate them for certain types of losses.

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Introduction to Business MGT 211

Insurable versus Uninsurable Risk--Insurance companies must avoid

certain risks. Insurers divide potential sources of lost in insurable and

uninsurable risks. An insurable risk must meet four criteria:

1. Predictability

2. Casualty

3. un-connectedness

4. Verifiability.

ii.

The Insurance Product

1. Liability Insurance--insurance covering losses resulting from

damage to people or property when the insured is judged

responsible.

2. Workers' Compensation Coverage--coverage provided by a

firm to employees for medical expenses, loss of wages, and

rehabilitation costs resulting from job-related injuries or disease.

3. Property Insurance--insurance covering losses resulting from

physical damage to or loss of the insured's real estate or

personal property.

4. Business Interruption Insurance--insurance covering income

lost during times when a company is unable to conduct business.

5. Life Insurance--insurance paying benefits to the policyholder's

survivors.

6. Group Life Insurance--insurance underwritten for a group as a

whole rather than for each individual in it.

7. Health Insurance--insurance covering losses resulting from

medical and hospital expenses as well as income lost from injury

or disease.

8. Disability Income Insurance--insurance providing continuous

income when disability keeps the insured from gainful

employment.

9. Special Health Care Providers

a. health maintenance organization (HMO)--organized

health care system providing comprehensive care in

return for fixed membership fees

b. preferred provider organization (PPO)--arrangement

whereby selected professional providers offer services at

reduced rates and permit thorough review of their service

recommendations

c. point-of-service (POS) plan-plan that allows member

patients to select a primary care doctor who provides

medical services but may refer patients to other providers

in the plan

10. Special Forms of Business Insurance

a. Key Person Insurance--special form of business

insurance designed to offset both lost income and

additional expenses.

b. Business Continuation Agreement--special form of

business insurance whereby owners arrange to buy the

interests of deceased associates from their heirs.

THE END

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