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Chapter 14


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McMaster University
Rita Cossa

Commerce 1E03 Chapter 14 Notes THE ROLE OF FINANCIAL MANAGERS ”what is finance?” and “what do financial managers do?” Finance: a functional area of business that acquires funds for the firm and manages those funds within the firm -activities include preparing budgets; doing cash flow analysis; and planning for the expenditure of funds on such assets as plant, equipment, and machinery Financial Management: the job of managing a firms resources so it can meet its goals and objectives Financial Managers: examine the financial data prepared by accountants and make recommendations to top executives regarding strategies for improving the health (financial strength) of the firm Financial decisions can only be made if you can understand accounting information THREE MOST COMMON WAYS FOR A FIRM TO FAIL FINANCIALLY: 1. Undercapitalization (lacking funds to start and run the business) 2. Poor Control over the cash flow 3. Inadequate expense control THE IMPORTANCE OF UNDERSTANDING FINANCE Parsley Patch Inc. was created by Bertani and Sherwood but they failed because they were not financial experts They hired a chartered accountant and an experienced financial manager, who taught them how to compute costs and how to control expenses If they had understood finance they would have not failed. Key word: failed THREE STEPS IN FINANCIAL PLANNING: 1. Forecasting both short-term and long-term financial needs 2. Developing budgets to meet those needs 3. Establishing financial control to see how well the company is doing what it set out to do FORECASTING FINANCIAL NEEDS 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 far as five or ten years into the future WORKING WITH THE BUDGET PROCESS Budget: sets forth managements expectations for revenues and, on the basis of those expectations, allocates the use of specific resources throughout the firm Operating (Master) Budget: ties together all of the firm’s other budgets and summarizes the business’s proposed financial activities (how much the firm will spend on supplies, travel, rent, advertising, research, salaries, and so forth) The operating (master) budget is generally the most detailed (firms will prepare this budget for each of their divisions/departments) and most used budget that a firm prepares Capital Budget: highlights a firm’s spending plans for major asset purchases that often requires large sums of money Cash Budget: estimates a firm’s projected cash inflows and outflows that the firm can use to plan for any cash shortages or surpluses during a given period When forecasting the cash budget, not only do you want to identify the projected increase or decrease in cash for the month, but you also want to ensure that you maintain a minimum cash balance (a safety level) you need to know when your projected cash balance may fall below the minimum, so that you can change how you will manage either you cash collection or your cash payments ESTABLISHING FINANCIAL CONTROLS Financial Control: a process in which a firm periodically compares its actual revenues, costs and expenses with its budget Most companies hold at least monthly financial reviews as a way to ensure financial control THE NEEDS FOR FUNDS Key areas include: 1. Managing day-to-day needs of the business 2. Controlling credit operations 3. Acquiring needed inventory 4. Making capital expenditures MANAGING DAY TO DAY NEEDS OF THE BUSINESS funds have to be available to meet all operational costs of the business Time value: -if someone offered to give you 200 dollars today or 200 dollars on year from today, you would benefit by taking the 200 dollars today. Why? You could invest the 200 dollars you receive today, or accumulate interest so your money could grow CONTROLLING CREDIT OPERATIONS Major problem today is that selling on credit is that a large percentage of a non- retailer’s business assets could be tied up in its credit accounts financial managers in such firms must develop efficient collection procedures Example: businesses often provide cash or quantity discounts to buyers who pay their accounts by a certain time AQUIRING INVENTORY effective marketing implies a clear customer orientation this focus on the customer means that high-quality service and availability of goods are vital if a business expects to prosper in today’s markets therefore to satisfy customers, businesses must maintain inventories that often involve a sizable expenditure of funds MAKING CAPITAL EXPENDITURES Capital Expenditures: are major investments in either tangible long-term assets such as land, buildings, and equipment, or intangible assets such as patents, trademarks, and copyrights. Developing new product ideas, and equipment to maintain or exceed current levels of output is essential ALTERNATIVE SOURCES OF FUNDS Debt Financing: refers to funds raised through various forms of borrowing that must be repaid Equity Financing: is money raised from within the firm (from operations) or through the sale of ownership in the firm (e.g. the sale of stock) Short-term Financing: refers to funds needed for one year or less Long-term Financing: refers to funds needed for a period longer than one year (usually two to ten years) Short Term Financing includes: trade credit, promissory notes, family and friends, financial institutions, factoring, short term loans, commercial paper, etc. Long Term Financing includes: Debt Financinglending institutions (loans) and selling bonds. Equity Financing Retained earnings, venture capital, and selling stocks OBTAINING SHORT TERM FINANCING Firms need to borrow short-term funds to purchase additional inventory or to meet bills that come due Most small businesses are primarily concerned with just staying afloat until they are able to build capital and creditworthiness. Until a business gets to that point, normally a lender will require some form of security for a loan TRADE CREDIT Trade Credit: the practice of buying goods or services now and paying for them later example: when a firm buys merchandise it receives an invoice (a bill) much like the one you receive when you buy something with a credit card Promissory Note: is a written contract with a promise to pay supplier a specific sum of money at a definite time they can be sold by the supplier to a bank at a discount FAMILY AND FRIENDS it is better not to borrow from family and friends because it is not binding and not safe commercial banks are less risky and have time limits If entrepreneurs decide to ask family and friends for financial assistance they both must: 1. Agree on specific loan terms 2. Put the agreement in writing 3. Arrange for repayment in the same way they would for a bank loan COMMERCIAL BANKS AND OTHER FINANCIAL INSTITUTIONS banks are highly sensitive to risk and are often reluctant to lend money to small new businesses, nonetheless, a promising and well-organized venture may be able to get a bank loan DIFFERENT FORMS OF SHORT-TERM LOANS Secured Loan: a loan that’s backed by something valuable such as a property. The item of value is called collateral if the borrower fails to pay the loan, the lender may take possession of the collateral Pledging: the process of accounts receivable are assets that are often used by businesses as collateral for a loan Unsecured loan: doesn’t require a borrower to offer the lending institution any collateral to obtain the loan (the loan is not backed by assets) Line of Credit: given amount of unsecured funds a bank will lend to a business (a line of credit is not guaranteed to a business) purpose is to speed the borrowing process Revolving Credit Agreement: a line of credit that’s guaranteed (however, banks usually charge a fee for guaranteeing such an agreement) Commercial Finance Companies: Organizations that make short term loans to borrowers who offer tangible assets as collateral FACTORING ACCOUNTS RECIEVABLE Factoring: the process of selling accounts receivable for cash How it works: a firm sells many of its products on credit to consumers and other businesses, creating a number of accounts receivable. Some of the buyers may be slow to pay their bills, causing the firm to have a large amount of money due to it. A factor is a market intermediary (usually a financial institution such as a commercial
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