One of the most critical aspects of management pertains to the finances of running a firm. Although there are numerous issues facing modern managers with respect to financial management, the following sections will address three of the most ubiquitous—acquisition of outside capital for start-up and growth, management of working capital and cash flow, and the construction and implementation of a capital budgeting process. Accessing the capital markets is fundamental for procuring funds that allow the firm to grow. Working capital involves managing the current assets and liabilities of the firm. Capital budgeting is the process of making long-term fixed asset investments.
In the initial start-up of any firm, management must procure the funds needed to get the business off the ground. These funds may come from a variety of sources, but managers should be aware that all assets are initially financed with either of two sources of capital—equity and debt. The capital markets represent the method by which external funds are made available to firms requiring outside capital infusions.
The equity markets are the means by which managers may raise capital by selling portions of the firm's ownership. The most common method is selling common stock in the firm. Outside investors provide the firm with new investment capital in exchange for ownership rights in the firm. As owners, stockholders receive voting rights and may participate in the financial success of the firm. In corporations, stockholders are protected by limited liability, meaning they are liable only for losses limited to the amount invested in the firm's stock; personal assets are protected against liability. Other sources of equity capital include contributions by the individual owner or owners from their own resources, and those made by family and friends of originators of the business.
Another method of raising equity capital involves the sale of preferred stock in the firm. Preferred stock promises to pay investors a stated dividend amount, and may also offer the opportunity for eventual conversion into common shares, commonly called convertible preferred stock. Preferred stock is particularly important for larger corporations as a source of funds because current tax law subsidizes the investment by one corporation in another corporation's preferred stock by exempting a portion of dividend income from taxation.
Other methods of equity capital attainment include the selling of warrants and rights. Warrants are securities that grant the holder the right to purchase a fixed number of common shares in the firm at a specified price for a specified period of time. Because warrants are stand-alone securities that may be traded among investors, the firm may raise new capital immediately through the sale of warrants while delaying the dilution of existing stockholders's interests until the warrants are exercised.
Rights are similar to warrants in that firms issue rights as a method of raising new equity capital. In a rights offering, the firm issues additional common stock to raise new capital. Rights are then issued to all outstanding shareholders, giving them the right to purchase shares in the new offering to avoid dilution of their pro-rata ownership in the firm. Through the use of rights, the firm is able to directly access the group of investors who are already interested in the firm's financial success, namely existing shareholders. Because rights have value in that they allow the purchase of new shares at a set subscription price, they are desired by shareholders and may be sold to others if the shareholder decides not to use the rights.
The other major market for outside capital is the debt market. The debt market is often vital to the financial success of a firm and managers must be familiar with, and have access to, outside sources of debt capital to ensure the survival of the firm. A common method of debt financing is borrowing from financial institutions. Banks, finance companies, and other lenders offer loans of varying terms that are critical for financial management, particularly short-term debt to alleviate temporary cash flow problems. A firm that experiences seasonal sales or uneven production schedules will sometimes utilize an established line of credit to borrow during times of capital needs and repay during times of cash surplus. By arranging credit lines prior to the capital need, managers assure that the firm will not experience sales or production interruptions due to cash shortages. For longer-term needs, negotiated notes from lenders serve as an intermediate source of debt financing.
For longer-term capital, the bond markets represent the primary source of debt financing. Bonds are debt securities in which investors become creditors of the firm in exchange for the right to receive payments of interest at regular intervals. For firms desiring to grow beyond local or regional status, access to the bond markets is critical for long-term capital needs, especially when firms do not desire to dilute existing ownership by offering additional equity financing.
Short-term financial issues for managers revolve around two primary areas; the management of current assets and current liabilities. Together, they constitute the overall management of cash flow for the firm. Cash flow management is absolutely critical to the financial survival of a firm, since a shortage of cash may result in a firm that shows a profit on its income statement actually going bankrupt by being unable to meet its financial obligations.
Management of a firm's current assets starts with the management of cash. Cash provides the liquidity needed to meet everyday obligations owed to creditors and suppliers and the flexibility to take advantage of new opportunities that may arise. Managing cash is a tricky issue for many firms; cash is a necessary component of daily operations, yet cash is a non-earning asset. Dollars tied up in cash (checking accounts) could be earning higher rates of return if invested in other areas. Larger corporations spend considerable time and resources in cash management, whereby dollars are transferred back and forth between cash accounts and marketable securities that earn a higher rate of return. As previously mentioned, negotiated credit lines serve to supplement depleted cash during periods of shortage.
Another critical issue is the management of accounts receivable. Receivables are money owed to the firm that has not yet been collected. They represent an important investment for the firm, since dollars not yet received cannot earn a positive return. The management of accounts receivable involves the determination and implementation of the firm's credit policy such as how long customers are allowed to pay for merchandise or services received and cash discounts for immediate rather than deferred payment. These are important financial issues for any manager: to whom does the company extend credit, for how much, and for how long? A tight credit policy may result in missed sales opportunities, since fewer potential customers will qualify for credit sales. Conversely, liberal credit terms may result in longer average collection periods and greater uncollected accounts. There are real costs associated with these issues, and managers must work to find appropriate trade-offs that result not only in higher sales, but also in the greatest profitability.
A third aspect of current asset management involves the management of inventories. Like receivables, inventory represents an investment of resources by the firm that has yet to pay off. On one hand, adequate inventory levels are necessary to ensure uninterrupted production schedules and to meet unexpected sales demand. However, too much inventory means dollars tied up in non-earning assets that could be devoted to more profitable investments. Managers must decide whether to attempt to coordinate production with sales patterns, or maintain level production regardless of current demand. These decisions spill over into other areas such as employee morale, since uneven or random production scheduling may result in temporary layoffs or overtime requirements. Again, managers utilize negotiated credit lines to access capital to maintain needed inventory materials when production and sales patterns differ.
Management of current liabilities involves accounts payable, short-term bank loans, lines of credit, and, for larger corporations, commercial paper. While the importance of short-term credit lines has already been discussed, accounts payable management is a critical issue, particularly for smaller firms. The longer a firm takes to pay its creditors, the longer it maintains access to and has the use of the funds. Thus, managers have every incentive to pay outstanding bills as slowly as possible. However, taking too long to pay may result in suppliers declining to offer future credit. Trade credit offered by suppliers is one of the most important sources of short-term financing for small firms that have limited access to other capital market sources. It is incumbent on managers to seek and negotiate the most favorable trade credit terms possible, since longer payment periods reduce potential cash flow problems and provide greater financial flexibility.
Larger corporations are able to issue commercial paper to provide short-term financial liquidity. Commercial paper is a short-term, unsecured note backed only by the firm's ability to repay. As such, only large, established firms find a market for their commercial paper. Firms such as General Motors use commercial paper as a regular source of short-term debt financing to cover cash flow shortages and provide the firm with ready liquidity.
Pulling together the management of current assets and liabilities results in the development of a cash budget. A cash budget is a schedule of expected cash inflows and outflows by a period that allows managers the ability to plan for and cover cash shortfalls and surpluses. A successful cash budget prevents the types of surprises or shortages that can result in financial crises such as the inability to pay creditors or purchase additional inventory to meet production needs.
Likewise, managers should work to monitor and manage the firm's cash conversion cycle. The cash conversion cycle consists, primarily, of three elements: the inventory conversion period, the receivable collections period, and the payables deferral period. The goal of effective cash management is to minimize the inventory conversion and receivables collection periods, and to maximize the payables deferral period. Through the successful management of current assets and liabilities, managers can maintain a cash conversion cycle that provides the firm with liquidity and profitability while avoiding the cash flow problems that so often result in financial distress.
The third major financial issue for managers involves long-term investments. This area, collectively known as capital budgeting, involves investment in fixed assets such as plant and equipment, new product and business analysis, and expansion and merger analysis. Capital budgeting is extremely important, because the decisions made involve the direction and opportunities for the future growth of the firm. The goal of corporate management is to maximize shareholder wealth; profitable capital projects result in increased firm value.
This process is also known as discounted cash flow analysis. The first step in evaluating a long-term investment opportunity is to estimate the net cash flows that would accrue to the firm. Managers should take care to use economically-sound techniques in cash flow analysis. All cash flows should be incremental (i.e., those that would otherwise not accrue to the firm unless this project or investment is undertaken). They should be on an after-tax basis; the only relevant cash flows are those that the firm will actually receive after all expenses and taxes are paid. Finally, sunk costs should not be included in the net cash flows associated with the project or investment. Only those cash flows associated with the future profitability of the investment should be included in the decision analysis. The proper economic decision is whether or not to invest today, and that decision is based on how the future cash flows will affect the present value of the firm. Past expenditures are not part of the analysis.
Once the project's net cash flows are determined, the timing of the cash flows should be considered. This is the discounted portion of discounted cash flow analysis. The decision of whether or not to invest is made in the present, so all dollars associated with the investment should be converted into present-value dollars. Managers must determine the proper interest rate at which to discount future cash flows. The discount rate should represent the opportunity cost of capital—the rate of return that could be earned on alternative investment projects of similar risk. Many firms set an internal "hurdle rate" for capital budgeting analysis, in effect saying no long-term investments will be undertaken that offer an expected rate of return lower than the hurdle rate. Normally, this rate is the weighted average cost of capital, which incorporates the firm's capital structure in determining the required rate of return on investment.
Once the net cash flows are determined and the discount rate has been established, managers should utilize a discounted cash flow method to evaluate and rank investment alternatives. The most economically-sound technique is net present value analysis (NPV), which involves discounting all future project cash flows back to the present using the firm's discount rate, then subtracting the net cost of the investment project. If the present value of the future cash-flow stream exceeds the present cost, then undertaking the project would add value to the firm today. The NPV method is congruent with the idea of management's goal to maximize the present value, which represents shareholder wealth, of the firm.
Another popular technique is the internal rate of return (IRR) method. The IRR is actually a special case of the NPV method. The internal rate of return is the unique discount rate that equates the present value of the future cash flow stream to the net cost of the project. If the IRR of the project is greater than the firm's hurdle rate, then the project offers a chance to earn a profitable return on investment and should be undertaken.
Finally, a third technique often used is the payback method. The payback method attempts to determine how long it will take for the project to recoup the total investment costs. Unlike the NPV and the IRR methods, the payback method is not a measure of profitability. Instead, it is a measure of time. Firms and managers often set a (subjective) hurdle period, such as no projects will be undertaken which do not recoup their initial costs in less than five years. The analysis then involves comparing the pay-back of the proposed investment to the firm's hurdle period. The payback method is popular because it provides an answer to a frequently-asked question—namely "how long before this investment pays for itself?" However, it is a flawed method because it does not consider all of the project's cash flows and does not consider the time value of money. Managers should employ the payback technique only in tandem with at least one of either the NPV or IRR discounted cash-flow methods.
Financial management is an integral aspect of managing a company. Accessing the capital markets to provide investment dollars, managing the working capital of the firm to ensure liquidity and flexibility, and making long-term investment decisions are all important issues that managers should address to allow the firm to grow and prosper.
Revised by Scott B. Droege
Block, Stanley B., and Geoffrey A. Hirt. Foundations of Financial Management. 11th ed. New York: McGraw-Hill, 2005.
Leach, J.C., and Ronald W. Melicher. Entrepreneurial Finance. 2nd ed. Mason, OH: Thomson South-Western, 2006.
Shapiro, Alan C. Capital Budgeting and Investment Analysis. Upper Saddle River, NJ: Prentice Hall, 2005.