Chapter 16: Mastering Financial Management PDF

Chapter 16 Mastering Financial Management © 2021 Cengage Learning. All R...

Chapter 16 Mastering Financial Management © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. LEARNING OBJECTIVES 16-1 Understand why financial management is important in today’s competitive economy. 16-2 Identify a business’s short- and long-term financial needs. 16-3 Summarise the process of planning for financial management. 16-4 Identify the services provided by banks and financial institutions for their business customers. 16-5 Describe the advantages and disadvantages of different methods of short-term debt financing. 16-6 Evaluate the advantages and disadvantages of equity financing. 16-7 Evaluate the advantages and disadvantages of long-term debt financing. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. FIGURE 16-1 Business Bankruptcies in South Africa © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Need for Financial Management Financial management – all the activities concerned with obtaining money and using it effectively Proper financial management must ensure that: Funds are available when needed both now and in the future, obtained at the lowest possible cost, and used as efficiently as possible. Financing priorities are established in line with organisational goals and objectives. Spending is planned and controlled. A business’s credit customers pay their bills on time, and the number of past due accounts is reduced. Bills are paid promptly to protect the business’s credit rating and its ability to borrow money. The funds required for paying the business’s taxes are available when needed to meet tax deadlines. Excess cash is invested in conservative, marketable securities. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Careers in Finance Typical job titles in finance include: Chief financial officer Financial manager Consumer credit officer Financial analyst Financial planner Insurance analyst Investment account executive Managers and employees in the finance area must: Be honest Have a strong background in finance, accounting, or mathematics Know how to use a computer to analyse data Be an expert at both written and oral communication © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. TABLE 16-1 Comparison of Short- and Long-Term Financing © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Short-Term Financing Short-term financing – money that will be used for one year or less Cash flow – the movement of money into and out of an organisation Speculative production – the time lag between the actual production of goods and when the goods are sold © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. FIGURE 16-2 Cash Flow for a Manufacturing Business © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Long-Term Financing Long-term financing – money that will be used for longer than one year © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Risk–Return Ratio Risk–return ratio – a ratio based on the principle that a high-risk decision should generate higher financial returns for a business and more conservative decisions often generate lower returns © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Planning – The Basis of Sound Financial Management Financial plan – a plan for obtaining and using the money needed to implement an organisation’s goals and objectives © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. FIGURE 16-3 The Three Steps of Financial Planning © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Developing the Financial Plan (slide 1 of 3) Establishing Organisational Goals and Objectives Goal – an end result that an organisation expects to achieve over a one- to ten-year period Objective – a specific statement detailing what an organisation intends to accomplish over a shorter period of time Budgeting for Financial Needs Budget – a financial statement that projects income, expenditures, or both over a specified future period Usually, the budgeting process begins with the construction of departmental budgets for sales and various types of expenses. Cash budget – a financial statement that estimates cash receipts and cash expenditures over a specified period © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. FIGURE 16-4 Cash Budget for Mzansi Clothing © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Developing the Financial Plan (slide 2 of 3) Budgeting for Financial Needs (cont.) Most businesses use one of two approaches to budgeting. 1. Traditional approach – a budgeting approach in which each new budget is based on the rand amounts contained in the budget for the preceding year, the amounts are modified to reflect any revised goals and managers are required to justify only new expenditures 2. Zero-base budgeting – a budgeting approach in which every expense in every budget must be justified To develop a plan for long-term financing needs, managers often construct a capital budget. Capital budget – a financial statement that estimates a business’s expenditures for major assets and its long-term financing needs © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Developing the Financial Plan (slide 3 of 3) Identifying Sources of Funds The four primary sources of funds are: 1. Sales revenue 2. Equity capital – money received from the owners or from the sale of shares of ownership in a business 3. Debt capital – borrowed money obtained through loans of various types 2. Proceeds from the sale of assets © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Traditional Banking Services for Business Clients (slide 1 of 2) Savings and Cheque Accounts Savings accounts provide a safe place to store money a business doesn’t immediately need. A business with excess cash it is willing to leave on deposit with a bank for a set period of time can earn a higher rate of interest. To do so, the business opens a fixed deposit account. Businesses also deposit money in cheque accounts. Even though cheque books have become obsolete, the cheque account offers benefits such as debit card purchases and text and email transaction notifications. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Traditional Banking Services for Business Clients (slide 2 of 2) Business Loans Short-term business loans: Must be repaid within one year or less To help ensure that short-term money will be available when needed, many businesses establish a line of credit. o Line of credit – a loan that is approved before the money is actually needed o Revolving credit agreement – a guaranteed line of credit Long-term business loans: Are repaid over a period of years Most lenders require some type of collateral for long-term loans. o Collateral – real estate or property pledged as security for a loan © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Credit and Debit Card Transactions In South Africa’s worsening economy, consumers are increasingly using credit cards for day-to-day expenses such as food and transport. Consumer debt rose to R1.6 trillion in 2019, the same year in which households were using 10 per cent of their expenditure just to service the interest on this debt. In return for processing the merchant’s credit-card transactions, the financial institution charges a fee that generally ranges between 2.5 and 3.5 per cent. Debit card – a card that electronically subtracts the amount of a customer’s purchase from her or his bank account at the moment the purchase is made © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Electronic Banking Services Electronic funds transfer (EFT) system – a means of performing financial transactions through a computer terminal Three EFT applications: 1. Automatic teller machines (ATMs) o Machines that provide almost any service a human teller can provide 2. Point-of-sale (POS) terminals o Computerised cash registers located in a retail store 3. EFT using internet banking o You log on to your internet banking profile, create a beneficiary and transfer funds from an account of your choice. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. International Banking Services Letter of credit – a legal document issued by a bank or other financial institution guaranteeing to pay a seller a stated amount for a specified period of time Certain conditions, such as delivery of the merchandise, may be specified before payment is made. Banker’s acceptance – a written order for a bank to pay a third party a stated amount of money on a specific date No conditions are specified; it is simply an order to pay without any strings attached. Both a letter of credit and a banker’s acceptance are popular methods of paying for import and export transactions. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sources of Unsecured Short-Term Financing (slide 1 of 3) Short-term debt financing is usually easier to obtain than long-term debt financing for three reasons: 1. For the lender, the shorter repayment period means less risk of non-payment. 2. The rand amounts of short-term loans are usually smaller than those of long-term loans. 3. A close working relationship normally exists between the short-term borrower and the lender. Most lenders do not require collateral for short-term financing. Unsecured financing – financing that is not backed by collateral © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sources of Unsecured Short-Term Financing (slide 2 of 3) Trade Credit Trade credit – a type of short-term financing extended by a seller who does not require immediate payment after delivery of merchandise It is the most popular form of short-term financing, because most manufacturers and wholesalers do not charge interest for trade credit. Promissory Notes Issued to Suppliers Promissory note – a written pledge by a borrower to pay a certain sum of money to a creditor at a specified future date Promissory notes usually require the borrower to pay interest. A promissory note offers two important advantages to the business extending the credit. 1. A promissory note is legally binding and an enforceable © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. contract. Sources of Unsecured Short-Term Financing (slide 3 of 3) Unsecured Bank Loans Prime interest rate – the lowest rate charged by a bank for a short- term loan Generally is reserved for large corporations with excellent credit ratings As a condition of an unsecured loan, a bank may require that a compensating balance be kept on deposit at the bank and that every commercial borrower clean up (pay off completely) its short-term loans at least once a year and not use short-term borrowing again for a period of 30 to 60 days. Commercial Paper Commercial paper – a short-term promissory note issued by a large corporation The interest rate a company pays when it sells commercial paper is tied to its credit rating and its ability to repay the commercial paper. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. FIGURE 16-5 Average Prime Interest Rate in South Africa, 1950 to 2020 © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sources of Secured Short-Term Financing Loans Secured by Inventory Finished goods, raw materials and work-in-process inventories may be pledged as collateral for short-term loans. Lenders prefer finished merchandise to raw materials or work-in- process inventories. Loans Secured by Receivables Accounts receivable – amounts owed to a business by its customers A business can pledge its accounts receivable as collateral to obtain short-term financing. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Factoring Accounts Receivable Factor – a business that specialises in buying other businesses’ accounts receivable The factor buys the accounts receivable for less than their face value; however, it collects the full face value rand amount when each account is due. The factor’s profit is the difference between the face value of the accounts receivable and the amount the factor has paid for them. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. TABLE 16-2 Comparison of Short-Term Financing Methods © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Selling Stock (slide 1 of 3) Initial Public Offering and the Primary Market Initial public offering (IPO) – occurs when a company sells common stock to the general public for the first time Example: Snap, the parent company of Snapchat, used an IPO to raise $3.4 billion. When a company uses an IPO to raise capital, the shares are sold in the primary market. Primary market – a market in which an investor purchases financial securities (via an investment bank) directly from the issuer of those securities o Investment banking firm – an organisation that assists corporations in raising funds, usually by helping to sell new issues of shares, bonds, or other investment securities © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. FIGURE 16-6 The Value of Initial Public Offerings in South Africa from 2014, forecast to 2021 © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Selling Stock (slide 2 of 3) Initial Public Offering and the Primary Market (cont.) Advantages of selling stock: The company is under no legal obligation to repay money obtained from the sale of stock. A company is under no legal obligation to pay dividends to shareholders. The Secondary Market Secondary market – a market for existing financial securities that are traded between investors Usually, secondary-market transactions are completed through a securities exchange or the over-the-counter (OTC) market. Securities exchange – a marketplace where member brokers meet to buy and sell securities Over-the-counter (OTC) market – a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Selling Stock (slide 3 of 3) Common Stock Common stock – stock whose owners may vote on corporate matters but whose claims on profits and assets are subordinate to the claims of others Preferred Stock Preferred stock – stock whose owners usually do not have voting rights but whose claims on dividends and assets are paid before those of common-stock owners © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Retained Earnings Retained earnings – the portion of a company’s profits not distributed to stockholders Because they are undistributed profits, retained earnings are considered a form of equity financing. The amount of retained earnings in any year is determined by corporate management and approved by the board of directors. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Venture Capital, Angel Investors, and Private Placements (slide 1 of 2) Venture capital – money invested in small (and sometimes struggling) businesses that have the potential to become very successful Generally, a venture capital firm consists of a pool of investors, a partnership established by a wealthy family, or companies with money to invest. In return for financing, these investors generally receive an equity or ownership position in the business and share in its profits. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Venture Capital, Angel Investors, and Private Placements (slide 2 of 2) Angel investor – an investor who provides financial backing for small business startups or entrepreneurs Unlike venture capitalists, angel investors are often focused on helping a business or an entrepreneur succeed rather than earning huge profits. Angel investors often provide more favourable financial terms when compared with venture capitalists and financial institutions. Private placement – occurs when stock and other corporate securities are sold directly to insurance companies, pension funds, large institutional investors, or mutual funds © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sources of Long-Term Debt Financing Financial leverage – the use of borrowed funds to increase the return on owners’ equity The principle of financial leverage works as long as a business’s earnings are larger than the interest charged for the borrowed money. For a small business, long-term debt financing is generally limited to loans, whereas large companies have the additional option of issuing corporate bonds. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. TABLE 16-3 Analysis of the Effect of Additional Capital from Debt or Equity for All Africa Acrylics © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Long-Term Loans Term-Loan Agreements Term-loan agreement – a promissory note that requires a borrower to repay a loan in monthly, quarterly, semiannual, or annual instalments The interest rate and repayment terms for term loans often are based on factors such as: The reasons for borrowing The borrowing business’s credit rating The value of collateral The lender usually requires some type of collateral. Lenders may also require that borrowers maintain a minimum amount of working capital. © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporate Bonds (slide 1 of 3) Corporate bond – a company’s written pledge that it will repay a specified amount of money with interest Interest rates for corporate bonds vary with the financial health of the company issuing the bond. Specific factors that increase or decrease the interest rate that a company must pay when it issues bonds include: o The company’s ability to pay interest each year until maturity o The company’s ability to repay the bond at maturity o Most corporate bonds are registered bonds. Registered bond – a bond registered in the owner’s name by the issuing company o Maturity date – the date on which a corporation is to repay borrowed money © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. FIGURE 16-7 The Risk–Return Ratio for Corporate Bond Investors © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporate Bonds (slide 2 of 3) Types of Bonds Debenture bond – a bond backed only by the reputation of the issuing company Mortgage bond – a corporate bond secured by various assets of the issuing company Convertible bond – a bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Corporate Bonds (slide 3 of 3) Repayment Provisions for Corporate Bonds Bond indenture – a legal document that details all the conditions relating to a bond issue A company may use one of three methods to ensure it has sufficient funds available to redeem a bond issue. 1. It can issue the bonds as serial bonds. o Serial bonds – bonds of a single issue that mature on different dates 2. The company can establish a sinking fund. o Sinking fund – a sum of money to which deposits are made each year for the purpose of redeeming a bond issue 3. A company can pay off an old bond issue by selling new bonds. Trustee – an individual or an independent company that acts as a bond owner’s representative © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. TABLE 16-4 Comparison of Long-Term Financing Methods © 2021 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.