I. Text managing financial resources

“Money makes the world go round”

(a popular English saying)

One of the primary considerations when going into business is money. Every company, from the little corner store to General Motors, worries about money – how to get it and how to use it. This area of concern, known as financial management, or finance, involves making decisions about alternative sources and uses of funds with the goal of maximizing the company’s value. In other words, financial management means effective acquisition and use of money.

A key goal of any business is to increase the value to its owners by making it grow. Maximizing the owners’ wealth sounds simple enough: Just sell a good product for more than it costs to make. Before you can earn any revenue, however, you need money to get started. Once the business is off the ground, your need for money continues. The money needed to start and continue operating a business is known as capital.

To start up or continue operating business, a company needs funds to purchase essential assets, support research and development, and buy materials for production. Capital is also necessary for salaries and wages, pensions, fees, credit extension for customers, advertising, insurance, and many other day-to-day operations. In addition, financing is essential for growth and expansion of a company. Because of competition in the market, capital needs to be invested in developing new product lines and production techniques and in acquiring assets for future expansion.

Generally speaking, a company wants to obtain money at the lowest cost and the least amount of risk. Therefore, financial managers should take into account cost of capital – the price a company must pay to raise money. Cost of capital depends on the risk associated with the company, the prevailing level of interest rates, and management’s selection of funding vehicles.

Where can a firm obtain the money it needs? The most obvious source would be revenues – cash received from sales, rentals of property, interest on short-term investments, and so on. Another likely source would be suppliers who may be willing to do business on credit, thus enabling the company to postpone payments. Most firms also obtain money in the form of loans from banks, finance companies, or other commercial lenders. In addition, public companies can raise funds by selling shares of stock, and large corporations can sell bonds.

It follows that business firms can raise money from internal (inside) and external (outside) sources Thus, a company uses two basic types of financing: equity financing and debt financing. Equity financing refers to funds that are invested by owners of the corporation. Debt financing refers to funds that are borrowed from sources outside the corporation.

Equity financing can be exemplified by the sale of corporate stock. This type of transaction describes an exchange of money for a share of business ownership – evidenced by a stock certificate. This form of financing allows a company to obtain funds without incurring debt; in other words, without having to repay a specific amount of money at any particular time. All corporations, regardless of their size, receive their starting capital from issuing and selling shares of stock. Equity financing has many advantages including increased liquidity ( there is now a public market for your shares ); voluntary dividend payments ( unlike creditors, stockholders do not have to be repaid at a fixed rate or time ); and enhanced visibility. The main disadvantages are high costs ( ranging from $50,000 to $500,000 ), loss of ownership control, increased filing requirements, and increased public visibility. Some companies use their excess cash to finance their growth. Using a company’s own money has one chief attraction: no interest payments are required. For this reason, many companies accumulate excess earnings over a period of time instead of paying dividends to shareholders. But a typical corporation prefers to keep a balance among different methods of raising money for expansion, frequently plowing back about half of the earnings into the business and paying out the other half as dividends. Unless some dividends are paid, investors may lose interest in the company. Some companies also raise money internally by selling assets that are no longer needed or obsolete.

Debt financing refers to what we normally think of as a loan. A creditor agrees to lend money to a debtor in exchange for repayment, with accumulated interest, at some future date. One of the biggest benefits of debt financing is that the lender does not gain an ownership interest in your business and your obligations are limited to repaying the loan. On the other hand, companies face some disadvantages of debt financing – especially when interest rates are high and the amount required is large. For example, a company can sell stock and survive rough times by omitting dividend payments, but if it can’t meet its loan and bond commitments, it could be forced into bankruptcy.

Debt financing can be either short or long. Short-term debt is any debt that will be repaid within one year, whereas long-term debt is any debt that will be repaid in a period longer than one year. The three major types of short-term debt are (1) trade credit from suppliers allowing purchasers to obtain products before paying for them, (2) short-term loans, and (3) commercial paper – short-term promissory notes of major corporations sold in minimum investments of $25,000 with a maturity or due date of 30 to 90 days. The three major types of long-term debt are loans, leases ( legal agreements that obligate the user of an asset to make payments to the owner of the asset in exchange for using it), and bonds – certificates that obligate the company to repay a certain sum, plus interest, to the bond-holder on specific dates. Thus, the bond has a maturity date, a deadline when the corporation must repay all of the money it has borrowed. If these obligations are not met, the company can be forced to sell its assets in order to make payments to the bondholders.

When choosing between debt and equity financing, financial managers consider a variety of issues, including the amount of financing required; whether it is for the short or long term; the cost of the financing including interest, fees, and other charges; timing; economic conditions, etc. Financial managers manage the company’s cash flow, coordinate and control the efficiency of operations, decide on specific investments and how to finance these investments and raise capital needed to support growth The responsibilities of a financial manager include forecasting and planning for the future and developing a financial plan. A financial plan is a document that shows the funds a firm will need for a period of time, as well as sources and uses of those funds. When developing a financial plan, the financial manager estimates the flow of money into and out of the business, determines whether cash flow is negative or positive and how to use and excess cash funds. He also chooses which capital investments should be made and selects the best way to finance these investments. Financial managers also coordinate and control the efficiency of operations, raise capital to support growth, and interact with banks and capital markets.

In smaller companies the owner is responsible for the firm’s financial decisions. In larger firms, however, financial planning is the responsibility of the finance department, which reports to a vice president of finance or chief financial officer. In fact, most financial managers are accountants.