CyberSummary

INTRODUCTION

Without effective management of assets, liabilities, and owners' equity, all businesses are doomed to fail. Financial management addresses issues pertaining to obtaining and managing funds and resources necessary to run a business successfully. All organizations must manage their resources effectively and efficiently if they are to achieve their objectives.

MANAGING CURRENT ASSETS AND LIABILITIES

Managing short-term assets and liabilities involves managing the current assets and liabilities on the balance sheet. Current assets are short-term resources such as cash, investments, accounts receivable, and inventory. Current liabilities are short-term debts such as accounts payable, accrued salaries, accrued taxes, and short-term bank loans. The terms current and short-term are used interchangeably because short-term assets and liabilities are usually replaced by new ones within three or four months and always within a year. Managing current assets and liabilities is sometimes called working capital management because short-term assets and liabilities continually flow through an organization and are thus said to be "working." The chief goal of financial managers who focus on current assets and liabilities is to maximize the return to the business on cash, temporary investments of idle cash, accounts receivable, and inventory.

A crucial element in financial management is effectively managing the firm's cash flow, the movement of money through the organization on a daily, weekly, monthly, or yearly basis. Astute money managers try to keep just enough cash on hand, called transaction balances, to pay bills, such as employee wages, supplies, and utilities as they fall due. To ensure that enough cash flows through the organization quickly, companies try to speed up cash collections from customers. One way to do this is to have customers send their payments to a lockbox, an address for receiving payments, instead of directly to the company's main address. Large firms with many stores or offices around the country can also use electronic funds transfer to speed up collections.

If cash comes in faster than it is needed to pay bills, businesses can invest the cash surplus for periods as short as one day or for as long as one year, until it is needed. Such temporary investments of cash are known as marketable securities. Many large companies invest idle cash in U.S. Treasury bills (T-bills), which are short-term debt obligations the U.S. government sells to raise money. Commercial certificates of deposit (CDs) are issued by commercial banks and brokerage companies. Unlike consumer CDs, which must be held until maturity, commercial CDs may be traded prior to maturity. A popular short-term investment for larger organizations is commercial paper--a written promise from one company to another to pay a specific amount of money. Some companies invest idle cash in international markets such as the Eurodollar market, a market for trading U.S. dollars in foreign countries.

Many businesses make the vast majority of their sales on credit, so managing accounts receivable is also an important task. To encourage quick payment, some businesses offer some of their customers 1 or 2 percent discounts if they pay off their balance within a specified period of time. Late payment charges of between 1 and 1.5 percent discourage slow payers. The larger the early payment discount offered, the faster customers will tend to pay their accounts; however, such discounts increase cash flow at the expense of profitability. Balancing the added advantages of early cash receipt against the disadvantages of reduced profits is difficult, as is determining the optimal balance between the higher sales likely to result from extending credit to customers with less than perfect credit and the higher bad-debt losses likely to result from a lenient credit policy.

While the inventory that a firm holds is controlled both by production needs and marketing considerations, the financial manager has to coordinate inventory purchases to manage cash flows. The object is to minimize the firm's investment in inventory without experiencing production cutbacks due to critical materials shortfalls or lost sales due to insufficient finished goods inventories. Optimal inventory levels are determined largely by the method of production. Inventory shortages can be as much of a drag on potential profits as too much inventory.

While having extra cash on hand is positive, a temporary cash shortfall can be a crisis. There are several potential sources of short-term funds to overcome a cash crunch. The most widely used source of short-term financing, and the most important account payable, is trade credit--credit extended by suppliers for the purchase of their goods and services. Most trade credit agreements offer discounts to organizations that pay their bills early. Virtually all organizations obtain short-term funds from banks. In most instances, the credit services granted these firms takes the form of a fixed dollar loan or a line of credit, an arrangement in which a bank agrees to lend a specified amount of money to the organization upon request--provided that the bank has the required funds to make the loan. Banks also make secured loans--loans backed by collateral that the bank can claim if the borrower does not repay the loan--and unsecured loans--loans backed only by the borrower's good reputation and previous credit rating. The principal is the amount of money borrowed; interest isa percentage of the principal that the bank charges for use of its money. The prime rate is the interest rate commercial banks charge their best customers (usually large corporations) for short-term loans. Additionally, most financial institutions, such as insurance companies, pension funds, money market funds, and finance companies, make short-term loans to businesses. In some instances, companies sell their accounts receivable to a finance company known as a factor, which gives the selling organizations cash and assumes responsibility for collecting the accounts. Additional nonbank liabilities that must be managed are taxes owed to the government and wages owed to employees.

MANAGING FIXED ASSETS

While most business failures are the result of poor short-term planning, successful ventures must also consider the long-term consequences of their actions. Managing the long-term assets and liabilities and the owners' equity portion of the balance sheet is important for the long-term health of the business. Long-term (fixed) assets are expected to last for many years--production facilities (plants), offices, equipment, furniture, automobiles, etc. In today's fast-paced world, companies need the most technologically advanced, modern facilities and equipment they can afford, but modern and high-tech equipment carries high price tags. Obtaining long-term financing can be challenging for even the most profitable organizations; for less successful firms, such challenges can prove nearly impossible.

The process of analyzing the business's needs and selecting the assets that will maximize its value is called capital budgeting, and the capital budget is the amount of money budgeted for investment in such long-term assets. All assets and projects must continually be reevaluated to ensure their compatibility with the organization's needs. If a particular asset does not live up to expectations, then management must determine why and take necessary corrective action.

Every investment carries some risk. When considering investments overseas, risk assessments must include the political climate and economic stability of a region. The longer a project or asset is expected to last, the greater its potential risk because it is hard to predict when a piece of equipment will wear out or become obsolete. The level of a project's risk is also affected by the stability and competitive nature of the marketplace and the world economy as a whole.

The ultimate profitability of any project depends not only on accurate assumptions of how much cash it will generate but also on its financing costs. Because a business must pay interest on borrowed funds, the returns from any project must cover both the costs of operating the project and the interest expenses for the debt used to finance its construction. The most efficient and profitable companies can attract the lowest-cost funds because they typically offer reasonable financial returns at low relative risks. Newer and less prosperous firms must pay higher costs to attract capital because these companies are riskier.

FINANCING WITH LONG-TERM LIABILITIES

To open a new store, build a new manufacturing facility, or research and develop a new product, companies need to raise low-cost, long-term funds. Two common choices for raising funds are attracting new owners (equity financing)and taking on long-term liabilities (debt financing).Long-term liabilities are debts that will be repaid over a number of years, such as long-term bank loans and bond issues. Companies may raise money by borrowing it from commercial banks or other financial institutions in the form of lines of credit, short-term loans, or long-term loans.

Aside from loans, most long-term debt takes the form of bonds, which are debt instruments that larger companies sell to raise long-term funds. In essence, the buyers of bonds (bondholders) loan the issuer of the bonds cash in exchange for regular interest payments until the loan is repaid on or before the specified maturity date. The bond itself is a certificate, an IOU, that represents the company's debt to the bondholder. Bonds are issued by corporations; national, state, and local governments; public utilities; and nonprofit corporations.

The bond contract, or indenture, specifies the terms of the agreement between the bondholders and the issuing organization. It specifies the face value of the bond and its initial sales price (typically $1,000). The price of the bond on the securities market will fluctuate along with changes in the economy and in the creditworthiness of the issuer. Bondholders receive the face value of the bond along with the final interest payment on the maturity date. The indenture also specifies the coupon, or annual interest, rate, which is the guaranteed percentage of face value that the company will pay to the bond owner every year. The bond indenture may also cover repayment methods, interest payment dates, procedures to be followed in case the organization fails to make interest payments, conditions for early repayment of the bonds, and any conditions related to collateral.

There are many different types of bonds. Most bonds are unsecured, meaning that they are not backed by specific collateral; such bonds are termed debentures. Secured bonds are backed by specific collateral that must be forfeited in the event that the issuing firm defaults. Whether secured or unsecured, bonds may be repaid in one lump sum or with many payments spread out over a period of time. Serial bonds are actually a sequence of small bond issues of progressively longer maturity. The firm pays off each of the serial bonds as they mature. Floating rate bonds do not have fixed interest payments; instead, the interest rate changes with current interest rates otherwise available in the economy. High-interest bonds, or junk bonds, offer relatively high rates of interest because they have higher inherent risks.

FINANCING WITH OWNERS' EQUITY

A second means of long-term financing is through equity. Sole proprietors and partners own all or a part of their businesses outright, and their equity includes the money and assets they have brought into their ventures. Corporate owners, however, own stock or shares of their companies, which they hope will provide them with a return on their investment. Stockholders' equity includes common stock, preferred stock, and retained earnings. Common stock, the single most important source of capital for most new companies, is often separated into two parts on the balance sheet--common stock at par and capital in excess of par. The par value of a stock is the dollar amount printed on the stock certificate and has no relation to actual market value--the price at which the common stock is currently trading. The difference between a stock's par value and its offering price is called capital in excess of par. Preferred stock is corporate ownership that gives the stockholder preference in the distribution of the company's profits, but not the voting and control rights accorded to common stockholders.

When a corporation has profits left over after paying all of its expenses and taxes, it can retain all or a portion of its earnings and/or pay them out to its shareholders in the form of dividends. Retained earnings are reinvested in the assets of the firm and belong to the owners in the form of equity. Retained earnings are an important source of funds and are, in fact, the only long-term funds that the company can generate internally. When a corporation distributes some of its profits to the owners, it issues them as cash dividend payments. Not all firms pay dividends. The dividend yield is the dividend per share divided by the stock price.

INVESTMENT BANKING

A company that needs more money may be able to obtain financing by issuing stock. Investment banking, the sale of stocks and bonds for corporations, helps companies raise funds by matching people and institutions with money to invest with corporations in need of resources to exploit new opportunities. The first-time sale of stocks and bonds directly to the public is called a new issue. When a company offers stock to the public for the very first time, it is said to be "going public," and the sale is called an initial public offering. New issues of stocks and bonds are sold directly to the public and to institutions in what is known as the primary market--the market where firms raise financial capital. The primary market differs from secondary markets, which are stock exchanges and over-the-counter markets where investors can trade their securities with others. Corporations usually employ an investment banking firm to help sell their securities in the primary market. An investment banker helps firms establish appropriate offering prices for their securities and takes care of the many details and securities regulations involved in the sale of securities.

THE SECURITIES MARKETS

Securities markets provide a mechanism for buying and selling securities. They make it possible for owners to sell their stocks and bonds to other investors, so they may be thought of as providers of liquidity--the ability to turn security holdings into cash quickly and at minimal expense and effort. Unlike the primary market in which corporations sell stocks directly to the public, secondary markets permit the trading of previously issued securities. There are many different secondary markets for both stocks and bonds. It is the active buying and selling by many thousands of investors that establishes the prices of all financial securities. Organized exchanges are central locations where investors buy and sell securities. Buyers and sellers are not actually present on the floor of the exchange, but are represented by brokers, who act as agents and buy and sell securities according to investors' wishes. The over-the-counter (OTC) market is a network of dealers all over the country linked by computers, telephones, and teletype machines. Since most corporate bonds and all U.S. securities are traded over-the-counter, the OTC market regularly accounts for the largest total dollar value of all of the secondary markets.

Performance measures--averages and indexes--help investors and professional money managers determine how well their investments performed relative to the market as a whole, and they help financial managers determine how their companies' securities performed relative to that of their competitors. Averages and indexes not only indicate the performance of a particular securities market, but provide a measure of the overall health of the economy. An index compares current stock prices with those in a specified base period, such as 1944, 1967, or 1977. An average isan average of certain stock prices. Some stock market averages are weighted averages, where the weights employed are the total market values of each stock in the index. Many investors follow the activity of the Dow Jones Industrial Average to see whether the stock market has gone up or down. A period of large increases in stock prices is known as a bull market, with the bull symbolizing an aggressive, charging market and rising stock prices. A declining stock market is known as a bear market, with the bear symbolizing a sluggish, retreating market. When stock prices decline very rapidly, the market is said to crash.