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.
Financial decisions affect both the profitability and the risk of a firm’s operations. An increase in cash holdings, for instance, reduces risk; but, because cash is not an earning asset, converting other types of assets to cash reduces the firm’s profitability. Similarly, the use of additional debt can raise the profitability of a firm (because it is expanding its business with borrowed money), but more debt means more risk. Striking a balance—between risk and profitability—that will maintain the long-term value of a firm’s securities is the task of finance.
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. Activity ratios, relating to the turnover of such asset categories as inventories, accounts receivable, and fixed assets, show how intensively a firm is employing its assets. 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 is used to compare a firm’s performance with that of other firms in the same industry or with the performance of industry in general. It is also used to study trends in the firm’s performance over time and thus to anticipate problems before they develop.
Profit planning
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.
Financial forecasting
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.
For the predicted level of sales, the financial manager estimates the funds that will be available from the company’s operations and compares this amount with what will be needed to pay for the new fixed assets (machinery, equipment, etc.). If the growth rate exceeds 10 percent a year, asset requirements are likely to exceed internal sources of funds, so plans must be made to finance them by issuing securities. If, on the other hand, growth is slow, more funds will be generated than are required to support the estimated growth in sales. In this case, the financial manager will consider a number of alternatives, including increasing dividends to stockholders, retiring debt, using excess funds to acquire other firms, or, perhaps, increasing expenditures on research and development.
Budgeting
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. Short-term budgets are formulated within the framework of the long-range plan. Normally, there is a budget for every individual product and for every significant activity of the firm.
Establishing budgetary controls requires a realistic understanding of the firm’s activities. For example, a small firm purchases more parts and uses more labour and less machinery; a larger firm will buy raw materials and use machinery to manufacture end items. In consequence, the smaller firm should budget higher parts and labour cost ratios, while the larger firm should budget higher overhead cost ratios and larger investments in fixed assets. If standards are unrealistically high, frustrations and resentment will develop. If standards are unduly lax, costs will be out of control, profits will suffer, and employee morale will drop.
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.
A firm may have excess cash for a number of reasons. There are likely to be seasonal or cyclic fluctuations in business. Resources may be deliberately accumulated as a protection against a number of contingencies. Since it is wasteful to allow large amounts of cash to remain idle, the financial manager will try to find short-term investments for sums that will be needed later. Short-term government or business securities can be selected and balanced in such a way that the financial manager obtains the maturities and risks appropriate to a firm’s financial situation.
Accounts receivable
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.
To evaluate a customer as a credit risk, the credit manager considers what may be called the five Cs of credit: character, capacity, capital, collateral, and conditions. Information on these items is obtained from the firm’s previous experience with the customer, supplemented by information from various credit associations and credit-reporting agencies. (See credit bureau.) In reviewing a credit program, the financial manager should regard losses from bad debts as part of the cost of doing business. Accounts receivable represent an investment in the expansion of sales. The return on this investment can be calculated as in any capital budgeting problem.
Inventories
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.
There is a standard procedure for determining the most economical amounts to order, one that relates purchasing requirements to costs and carrying charges (i.e., the cost of maintaining an inventory). While carrying charges rise as average inventory holdings increase, certain other costs (ordering costs and stock-out costs) fall as average inventory holdings rise. These two sets of costs constitute the total cost of ordering and carrying inventories, and it is fairly easy to calculate an optimal order size that will minimize total inventory costs. The advent of computerized inventory tracking fostered a practice known as just-in-time inventory management and thereby reduced the likelihood of excess or inadequate inventory stocks.
Short-term financing
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.
Trade credit
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
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.
A basic limitation of the commercial-paper market is that its resources are limited to the excess liquidity that corporations, the main suppliers of funds, may have at any particular time. Another disadvantage is the impersonality of the dealings; a bank is much more likely to help a good customer weather a storm than is a commercial-paper dealer.
Secured 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.
Financing through accounts receivable can be done either by pledging the receivables or by selling them outright, a process called factoring in the United States. When a receivable is pledged, the borrower retains the risk that the person or firm that owes the receivable will not pay; this risk is typically passed on to the lender when factoring is involved.
When loans are secured by inventory, the lender takes title to them. He may or may not take physical possession of them. Under a field warehousing arrangement, the inventory is under the physical control of a warehouse company, which releases the inventory only on order from the lending institution. Canned goods, lumber, steel, coal, and other standardized products are the types of goods usually covered in field warehouse arrangements.
Intermediate-term financing
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.
Term loans
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.
Term loans involve more risk to the lender than do short-term loans. The lending institution’s funds are tied up for a long period, and during this time the borrower’s situation can change markedly. To protect themselves, lenders often include in the loan agreement stipulations that the borrowing company maintain its current liquidity ratio at a specified level, limit its acquisitions of fixed assets, keep its debt ratio below a stated amount, and in general follow policies that are acceptable to the lending institution.