Chapter 8: Managing Financial Resources

Overview of Business Finance

Business finance is one of the main fields of decision making for business managers.

Business finance decisions are related to the resources of a business and they can be grouped as:

• Investment decisions
• Financing decisions
• Operating decisions

Investment decisions are about making sound investment choices in line with business strategies and economic analysis. Investment decisions mainly include decisions related to current assets and fixed assets. Current assets can be converted into cash in a relatively short period; whereas fixed assets can be converted into cash in a longer time of period.

Financing decisions contain decisions about how much profit to distribute as well as how to finance the resources of the company. Businesses should select the optimum mix of internal and external funds to finance the investments of the business. The combination of internal funds and external funds creates the financing structure, in other words the capital structure of the company. Internal funds are generated by retaining those profits which are not distributed as dividends to the shareholders. The best mix of debt financing and equity financing depends on the type of the industry in which the company operates and general economic conditions as well as market timing, managers’ risk appetite, flexibility of management, and other factors.

Operating decisions focus on the efficient use of resources to create competitive advantage in the market by developing effective and cost efficient systems and processes such as production, service, information, and technology

Financial Markets

Suppliers of funds and demanders of funds come together in financial markets to exchange savings or funds in return for financial claims or securities.

Financial markets serve many roles such as:

• Efficient allocation of capital
• Price discovery
• Liquidity
• Risk Sharing

Financial institutions such as commercial banks, mutual funds, and pension funds create and sell assets with different risk characteristics for different type of investors.

Financial markets can be classified as:

• Money markets
• Capital markets

Money markets include short-term securities like commercial paper and treasury bills. Capital markets include long-term securities like bonds and stocks. Long- term securities have a maturity longer than 1 year.

Short-Term Financial Management

Companies can generate more cash flows and value by managing their working capital efficiently. Working capital includes current asset investments of the firm, which comprises assets that can be converted into cash within one year. Net Working Capital refers to the current assets of the firm less the current liabilities.

Working capital can be financed by accrued wages and salaries, accrued taxes, short term loans provided from commercial banks, finance companies or factors, issuing commercial papers (short-term promissory notes).

Companies need to plan for the future to predict future financing requirements and prepare for future needs using pro forma financial statements . Pro forma income statement exhibits forecasted revenues and expenses for a future period whereas pro forma balance sheet displays forecasted assets and total financing provided by debt and equity financing at a future date.

Financial managers must prepare plans to finance the financing requirements that will arise. Otherwise, companies may face insolvency risks.

Financial managers employ budgets for short term planning. A budget is a plan to show how much money a person or organization will earn and how much they will need or be able to spend.

Long-Term Financing

Companies usually finance their long-term assets with long-term resources such as:

• Long-term trade credit
• Long-term leasing
• Long-term bank loans
• Issuing bonds
• Issuing stocks

Suppliers may extend trade credit to their customers for a long time especially when they sell fixed assets. Capital lease is a lease agreement by which the lessee rents the property and makes regular payments to the lessor for a specified number of months or years. Banks may grant a business a line of credit by which the business can borrow funds to fulfill its long-term financing needs. As the party issuing the bonds, the company sells the bonds to bond investors and provides financing. A bond is a promissory note with a fixed interest rate, contractual payments, and a principal. On the other hand, companies raise capital by issuing shares of stock. Stocks represent ownership interest in the business and its assets.

Financing decisions involve debt or equity financing. Bond issuances provide debt financing whereas issuing shares of stock provide equity financing. Stocks grant the holders:

• Limited liability in case of bankruptcy.
• Claim on income in the form of dividends.
• Claim on assets if the business goes bankrupt.
• Voting rights in the election of the Board of Directors.
• Preemptive rights.

Preemptive rights gives the preferred stockholders the right to purchase new shares of stock proportionate with their existing share of ownership.

Capital Investment Decisions

Capital investment decisions are related to long-term investments of businesses. Activities of planning and evaluating investment projects is called capital budgeting, which involves economic analysis and selection of projects according to some criteria determined by the management of the company. Managers focus on changes in the cash flows of the firm to evaluate the profitability of an investment project.

It is difficult to find remarkably profitable projects in efficient markets. Efficient markets are markets where all valid information is available to all participants at the same time, and where prices respond immediately to available information.

Firms utilize various techniques to assess profitability of investment projects such as:

• NPV
• IRR
• PBP

Net Present Value (NPV) shows the amount of wealth that is expected to be created if the project is undertaken.

Internal Rate of Return (IRR) is the discount rate that makes the NPV of the project equal to zero.

Payback period ( PBP) is the number of years needed to recover the initial investment outlay

Financial Risk Management

Return of an investment is the expected benefits of the investment in the form of cash flows. Risk can be defined as the potential variability in future cash flows.

Basic types of risk for a business can be classified as:

• Credit risk (Default risk)

The risk that a company or individual will not be able to pay the contractual interest or principal on its debt obligations.

• Market risk

The risk that the value of an investment to fluctuate due to general market conditions.

• Political risk

The risk that a country's government will suddenly change its policies.

• Operational risk

Various risks that can arise from a company's ordinary business

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. Investing in a portfolio of stocks, investors can get rid of some of the risk by investing across different securities which do not tend to move precisely together. An investment portfolio is like a pie that is divided into pieces of a variety of asset classes and/or types of investments in different sizes.

Shareholder Value Management

Financial decisions play a vital role the value creation of businesses. Companies can create value if they can achieve economic returns above the cost of capital on their existing and new investments. When companies make effective choices related to financing decisions, they can enhance the goal of maximizing shareholder wealth. By offering the right products and services in a cost effective manner by efficient economic analysis, companies can gain competitive advantage and generate long-term cash flows to enhance value creation.

Before the new millennium, the emphasis was on profit margins, whereas nowadays new value measures are in place such as Economic Profit or Economic Value Added (EVA) and Cash Flow Return on Investment (CFROI) to assess how management actions reflect on the shareholder value results.

Ethics in Financial Management

Dealing with ethical problems is an important challenge especially in the field of financial management. Companies must comply with legal regulations and corporate governance principles to curb ethical problems.

Corporate Governance can provide the business procedures for proper supervision, control, and information-flows to serve as a system of checks-and- balances. Companies can also establish internal control systems to fight against fraud and corruption.

Lastly, companies should consider the effects of their activities on their stakeholders. The main stakeholders of the business are:

• Customers
• Suppliers
• Employees
• Environment
• Government
• Competitors
• Investors
• Society