Business finance, the raising and managing of funds by business organizations. Planning, analysis, and control operations are responsibilities of the financial manager, who is usually close to the top of the organizational structure of a firm. In very large firms, major financial decisions are often made by a finance committee. In small firms, the owner-manager usually conducts the financial operations. Much of the day-to-day work of business finance is conducted by lower-level staff; their work includes handling cash receipts and disbursements, borrowing from commercial banks on a regular and continuing basis, and formulating cash budgets.
Short-Term Financial Operations
Financial planning and control
Short-term financial operations are closely involved with the financial planning and control activities of a firm. These include financial ratio analysis, profit planning, financial forecasting, and budgeting.
Financial ratio analysis
A firm’s balance sheet contains many items that, taken by themselves, have no clear meaning. Financial ratio analysis is a way of appraising their relative importance. The ratio of current assets to current liabilities, for example, gives the analyst an idea of the extent to which the firm can meet its current obligations. This is known as a liquidity ratio. Financial leverage ratios (such as the debt–asset ratio and debt as a percentage of total capitalization) are used to make judgments about the advantages to be gained from raising funds by the issuance of bonds (debt) rather than stock. A firm’s primary operating objective is to earn a good return on its invested capital, and various profit ratios (profits as a percentage of sales, of assets, or of net worth) show how successfully it is meeting this objective.
Ratio analysis applies to a firm’s current operating posture. But a firm must also plan for future growth. This requires decisions as to the expansion of existing operations and, in manufacturing, to the development of new product lines. A firm must choose between productive processes requiring various degrees of mechanization or automation—that is, various amounts of fixed capital in the form of machinery and equipment. This will increase fixed costs (costs that are relatively constant and do not decrease when the firm is operating at levels below full capacity). The higher the proportion of fixed costs to total costs, the higher must be the level of operation before profits begin, and the more sensitive profits will be to changes in the level of operation.
The financial manager must also make overall forecasts of future capital requirements to ensure that funds will be available to finance new investment programs. The first step in making such a forecast is to obtain an estimate of sales during each year of the planning period. This estimate is worked out jointly by the marketing, production, and finance departments: the marketing manager estimates demand; the production manager estimates capacity; and the financial manager estimates availability of funds to finance new accounts receivable, inventories, and fixed assets.
Once a firm’s general goals for the planning period have been established, the next step is to set up a detailed plan of operation—the budget. A complete budget system encompasses all aspects of the firm’s operations over the planning period. It may even allow for changes in plans as required by factors outside the firm’s control.
Budgeting is a part of the total planning activity of the firm, so it must begin with a statement of the firm’s long-range plan. This plan includes a long-range sales forecast, which requires a determination of the number and types of products to be manufactured in the years encompassed by the long-range plan.
The cash budget
One of the principal methods of forecasting the financial needs of a business is the cash budget, which predicts the combined effects of planned operations on the firm’s cash flow. A positive net cash flow means that the firm will have surplus funds to invest. But if the cash budget indicates that an increase in the volume of operations will lead to a negative cash flow, additional financing will be required. The cash budget thus indicates the amount of funds that will be needed or available month by month or even week by week.
Accounts receivable are the credit a firm gives its customers. The volume and terms of such credit vary among businesses and among nations; for manufacturing firms in the United States, for example, the ratio of receivables to sales ranges between 8 and 12 percent, representing an average collection period of approximately one month. The basis of a firm’s credit policy is the practice in its industry; generally, a firm must meet the terms offered by competitors. Much depends, of course, on the individual customer’s credit standing.
Every company must carry stocks of goods and materials in inventory. The size of the investment in inventory depends on various factors, including the level of sales, the nature of the production processes, and the speed with which goods perish or become obsolete.
The problems involved in managing inventories are basically the same as those in managing other assets, including cash. A basic stock must be on hand at all times. Because the unexpected may occur, it is also wise to have safety stocks; these represent the little extra needed to avoid the costs of not having enough. Additional amounts—anticipation stocks—may be required for meeting future growth needs. Finally, some inventory accumulation results from the economies of purchasing in large quantities; it is always cheaper to buy more than is immediately needed, whether of raw materials, money, or plant and equipment.
The main sources of short-term financing are (1) trade credit, (2) commercial bank loans, (3) commercial paper, a specific type of promissory note, and (4) secured loans.
A firm customarily buys its supplies and materials on credit from other firms, recording the debt as an account payable. This trade credit, as it is commonly called, is the largest single category of short-term credit. Credit terms are usually expressed with a discount for prompt payment. Thus, the seller may state that if payment is made within 10 days of the invoice date, a 2 percent cash discount will be allowed. If the cash discount is not taken, payment is due 30 days after the date of invoice. The cost of not taking cash discounts is the price of the credit.
Commercial bank loans
Commercial bank lending appears on the balance sheet as notes payable and is second in importance to trade credit as a source of short-term financing. Banks occupy a pivotal position in the short-term and intermediate-term money markets. As a firm’s financing needs grow, banks are called upon to provide additional funds. A single loan obtained from a bank by a business firm is not different in principle from a loan obtained by an individual. The firm signs a conventional promissory note. Repayment is made in a lump sum at maturity or in installments throughout the life of the loan. A line of credit, as distinguished from a single loan, is a formal or informal understanding between the bank and the borrower as to the maximum loan balance the bank will allow at any one time.
Commercial paper, a third source of short-term credit, consists of well-established firms’ promissory notes sold primarily to other businesses, insurance companies, pension funds, and banks. Commercial paper is issued for periods varying from two to six months. The rates on prime commercial paper vary, but they are generally slightly below the rates paid on prime business loans.
Most short-term business loans are unsecured, which means that an established company’s credit rating qualifies it for a loan. It is ordinarily better to borrow on an unsecured basis, but frequently a borrower’s credit rating is not strong enough to justify an unsecured loan. The most common types of collateral used for short-term credit are accounts receivable and inventories.
Whereas short-term loans are repaid in a period of weeks or months, intermediate-term loans are scheduled for repayment in 1 to 15 years. Obligations due in 15 or more years are thought of as long-term debt. The major forms of intermediate-term financing include (1) term loans, (2) conditional sales contracts, and (3) lease financing.
A term loan is a business credit with a maturity of more than 1 year but less than 15 years. Usually the term loan is retired by systematic repayments (amortization payments) over its life. It may be secured by a chattel mortgage on equipment, but larger, stronger companies are able to borrow on an unsecured basis. Commercial banks and life insurance companies are the principal suppliers of term loans. The interest cost of term loans varies with the size of the loan and the strength of the borrower.
Conditional sales contracts represent a common method of obtaining equipment by agreeing to pay for it in installments over a period of up to five years. The seller of the equipment continues to hold title to the equipment until payment has been completed.
Conditional sales contracts
It is not necessary to purchase assets in order to use them. Railroad and airline companies in the United States, for instance, have acquired much of their equipment by leasing it. Whether leasing is advantageous depends—aside from tax advantages—on the firm’s access to funds. Leasing provides an alternative method of financing. A lease contract, however, being a fixed obligation, is similar to debt and uses some of the firm’s debt-carrying ability. It is generally advantageous for a firm to own its land and buildings, because their value is likely to increase, but the same possibility of appreciation does not apply to equipment.
Long-Term Financial Operations
Long-term capital may be raised either through borrowing or by the issuance of stock. Long-term borrowing is done by selling bonds, which are promissory notes that obligate the firm to pay interest at specific times. Secured bondholders have prior claim on the firm’s assets. If the company goes out of business, the bondholders are entitled to be paid the face value of their holdings plus interest. Stockholders, on the other hand, have no more than a residual claim on the company; they are entitled to a share of the profits, if there are any, but it is the prerogativeof the board of directors to decide whether a dividend will be paid and how large it will be.
There are various forms of long-term debt. A mortgage bond is one secured by a lien on fixed assets such as plant and equipment. A debenture is a bond not secured by specific assets but accepted by investors because the firm has a high credit standing or obligates itself to follow policies that ensure a high rate of earnings. A still more junior lien is the subordinated debenture, which is secondary (in terms of ability to reclaim capital in the event of a business liquidation) to all other debentures and specifically to short-term bank loans.
Equity financing is done with common and preferred stock. While both forms of stock represent shares of ownership in a company, preferred stock usually has priority over common stock with respect to earnings and claims on assets in the event of liquidation. Preferred stock is usually cumulative—that is, the omission of dividends in one or more years creates an accumulated claim that must be paid to holders of preferred shares. The dividends on preferred stock are usually fixed at a specific percentage of face value.
Earnings and dividend policies
The size and frequency of dividend payments are critical issues in company policy. Dividend policy affects the financial structure, the flow of funds, corporate liquidity, stock prices, and the morale of stockholders. Some stockholders prefer receiving maximum current returns on their investment, while others prefer reinvestment of earnings so that the company’s capital will increase.
Convertible bonds and stock warrants
Companies sometimes issue bonds or preferred stock that give holders the option of converting them into common stock or of purchasing stock at favourable prices. Convertible bonds carry the option of conversion into common stock at a specified price during a particular period. Stock purchase warrants are given with bonds or preferred stock as an inducement to the investor, because they permit the purchase of the company’s common stock at a stated price at any time. Such option privileges make it easier for small companies to sell bonds or preferred stock. They help large companies to float new issues on more favourable terms than they could otherwise obtain. When bondholders exercise conversion rights, the company’s debt ratio is reduced because bonds are replaced by stock.
Growth And Decline
Companies often grow by combining with other companies. One company may purchase all or part of another; two companies may merge by exchanging shares; or a wholly new company may be formed through consolidation of the old companies. From the financial manager’s viewpoint, this kind of expansion is like any other investment decision; the acquisition should be made if it increases the acquiring firm’s net present value as reflected in the price of its stock.
When a firm cannot operate profitably, the owners may seek to reorganize it. The first question to be answered is whether the firm might not be better off by ceasing to do business. If the decision is made that the firm is to survive, it must be put through the process of reorganization. Legal procedures are always costly, especially in the case of business failure; both the debtor and the creditors are frequently better off settling matters on an informal basis rather than through the courts.