MGM101H5 Lecture Notes - Unsecured Debt, Cash Flow, Revolving Credit
Chapter 17 Outline
The Role of Finance and Financial Management
● Financial activities include preparing budgets, doing cash flow analysis, and planning for
the expenditure of funds on assets.
● Accountant records data, financial managers analyze data
● Accountants need to know finance and vice versa. In large corporations, CFO is in
charge of both departments.
● Financial managers examine financial data and make recommendations to top
executives on how to improve financial strength of firm
● Most common ways for small businesses to fail are: undercapitalization, poor cash flow
control, and poor expense control.
The Importance to Understanding Finance
● Financial managers have to be aware of changes in financial regulations such as tax
● Financial department is also responsible for internal auditing, which is a strategic
approach to checking the work of accountants.
● Objective is to optimize firm’s profitability and make the best use of its money. This is
done by analyzing past short-term and long-term money flows. Therefore, it is easier to
financially manage a old firm, which has had records and experience, than a new firm.
● Three steps in financial planning are: (1) forecasting financial needs (2) budgeting and
(3) establishing financial controls (reflection and change).
Forecasting Financial Needs
● A short-term forecast predicts revenues, costs, cash flow, and expenses for a period of
one year or less.
● Long term forecast predicts revenues, costs, expenses and cash flow for a period longer
than one year.
● Long-term forecast is crucial in budgeting and setting up company strategies.
Working with the Budget Process
● A budget is a financial plan that allocates resources based on the forecast. The three
types are operating budget, capital budget, and cash budget.
● An operating budget, or master budget, ties all the firm’s individual budgets together to
form a summary. Typically created annually; monthly budgets are created.
● Ultimately, the firm’s board of directors have to approve all budgets and this can take a
lot of time.
● A capital budget highlights the firm’s spending plans for major assets that require large
sums of money.
● Cash budget estimates a firm’s projected inflows and outflows and is used to plan any
cash shortages or surpluses in a given period.
Establishing Financial Controls
● Financial control is a process where firms compare their budget with what actually
happened in terms of revenues, costs, and expenses. This is usually done on a monthly
basis. Financial control allows managers to take corrective action if necessary.
The Need for Funds
● This section outlines the areas where firms need funds
Managing Day-to-Day Needs of the Business
● Sound financial managements means that firms can meet daily cash needs such as tax
payments and wage payments.
● Financial managers try to keep expenditures to a minimum to rack up on the time value
● On the same principle, financial managers attempt to pay bills as late as possible and
collect payments as soon as possible.
Controlling Credit Operations
● Credit is important; customers like to pay on credit. But it creates the problem for the
firm to having to pay bills but having all of its money tied up in account receivables.
Therefore, companies have to (1) make sure to have enough available funds on hand (2)
set up efficient credit collection systems and (3) only sell to those with good credit
● Accepting business from MasterCard or Visa holders is a solution because those who
can apply for these cards are guaranteed to have good credit history
● Retail businesses are required to put a significant amount of funds in inventory. A
carefully constructed inventory policy like that of “Just in Time” works well.
● A poorly managed inventory system can seriously affect cash flow and drain finances
● It is important to not keep to much inventory because of opportunity cost (because of
time value of money)
Making Capital Expenditures
● Capital expenditures are major investments in either tangible assets (land, building,
equipment) or intangible assets (patents, trademarks, copyrights)
● Expansion into new markets is expensive without guarantee of return so businesses
have to carefully weigh out their options.
Obtaining Short-Term Financing
● Short-term financing = funds needed for one year or less
● Most small businesses can only do short-term financing, and need to offer collateral
before they can build enough credit-worthiness.
● The practice of buying goods and services now and paying for them later. This is the
least expensive and most convenient way of short-term financing.
● 2/10, net 30 means that businesses can get a 2% discount if paid within 10 days, but the
regular price if paid after 10 days and before 30 days.
● Businesses that hesitate to do businesses with customer due to the customer’s lack of
credit-worthiness can get him to sign a promissory note, which is a written contract with
promise to pay. The suppliers can sell these notes to the bank at a discount.
Family and Friends
● Not recommended -- can tear friends and family apart. Better to go to a bank where
they understand the business’ risks and can analyze the firm’s future financial risks.
Commercial Banks and Other Financial Institutions
● Businesses that do manage to get loans from banks should send all financial statements
to the bank (build relation) so that the bank continues to supply funds when needed.
● Bankers want to see a cash flow forecast. In small businesses, business owners usually
do this themselves.
● Businesses want you to succeed as much as you do because they will earn interest as
part of the repayment of your loans.
Different forms of Short-Term Loans
● Secured loan is loan that is backed by something valuable (a collateral).
● Account receivables can be used as a collateral for a loan; this is called pledging. Also,
a percentage of an account receivable (usually 75%) can be used.
● Other examples of collateral include raw materials (steel, coal), buidlings, machinery,
stocks, and bonds
● An unsecured loan is one that does not require any collateral. Only given to highly
regarded customers who are seen as less risky.
● A line of credit is a given amount of unsecured funds a bank will lend to a business. This
speeds the borrowing process because firms do not need to go through the application
process every time it needs a loan. Line of credit increases as businesses become
more financially secure.
● Revolving credit agreement is a line of credit that is guaranteed. Banks usually charge a
fee for guaranteeing such an agreement.
● An alternative to a bank is a commercial finance company. These non-banks offer short-
term loans to companies who offer collateral. They charge very high interest rates.
Factoring Accounts Receivable
● A factor is a financial institution that agrees to buy a company’s account receivables at a
discount, for cash. It keeps the money that the accounts receive. This is an expensive
way to earn money, but is popular among small businesses. Factoring discount rates
are higher than loan rates, but many small businesses do not qualify for loans.
● Factoring is a sale of an asset rather than a loan.
● Companies can reduce the discount if they agree to reimburse slow-paying accounts or
accounts that do not pay at all.
● Used by companies to raise funds for a few months but wants to get lower interest rates
than those charged by banks