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Chapter 17 Notes (on Finance II)

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James Appleyard

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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 deductions etc. ● Financial department is also responsible for internal auditing, which is a strategic approach to checking the work of accountants. Financial Planning ● 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 of money ● 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 history. ● 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 Acquiring Inventory ● 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 dry ● 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. Trade Credit ● 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-
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