Chapter 9: Finance

Financial Capital The funds a firm uses to acquire its assets and finance its operations
Finance The functional area of business that is concerned with finding the best sources and uses of financial capital
Risk The degree of uncertainty regarding the outcome of a decision
Financial Ratio Analysis Computing ratios that compare values of key accounts listed on a firm’s financial statements
Liquidity Ratios Financial ratios that measure the ability of a firm to obtain the cash it needs to pay its short-term debt obligations as they come due
Financial Leverage The use of debt in a firm’s capital structure
Leverage Ratios Ratios that measure the extent to which a firm relies on debt financing in its capital structure
Profitability Ratios Ratios that measure the rate of return a firm is earning on various measures of investment
Line of Credit A financial arrangement between a firm and a bank in which the bank pre-approves credit up to a specified limit, provided that the firm maintains an acceptable credit rating
Retained Earnings The part of a firm’s net income it reinvests
Covenant A restriction lenders impose on borrowers as a condition of providing long-term debt financing
Equity Financing Funds provided by the owners of a company
Debt Financing Funds provided by lenders (creditors)
Capital Structure The mix of equity and debt financing a firm uses to meet its permanent financing needs
Time Value of Money The principle that a dollar received today is worth more than a dollar received in the future
Present Value The amount of money that, if invested today at a given rate of interest (called the discount rate), would grow to become some future amount in a specified number of time periods
Net Present Value (NPV) The sum of the present values of expected future cash flows from an investment, minus the cost of that investment
What is the goal of financial management and what issues do financial managers confront? GOALS: maximize the value of the firm to its owners, as well as upholding responsibilities to customers, employees, and other stakeholders. ISSUES: conflicting goals between stakeholders and stockholders, balance between risk and return (risk-return tradeoff means that the higher the risk, the greater the return).
What are the tools financial managers use to evaluate their company’s financial conditions and develop future plans? Computing ratios based on key accounts listed on their firm’s financial statements, four types of ratios: liquidity ratios (will firm have enough cash to pay for its short-term liabilities), asset management ratios (how effectively firm is using various assets to generate revenues), leverage ratios (extent to which firm relies on debt in its capital structure), and profitability ratios (overall success at using resources to create a profit). Budgeted income statement (develops forecast of net income for planning period), budgeted balance sheet (forecasts the types and amounts of assets the firm will need to implement its plans), and cash budget (identifies the timing of cash inflows and outflows to help firm identify surpluses/shortages of cash) are also key tools managers use to develop and present their financial plans.
How are the major sources of funds evaluated to meet a firm’s short-term and long-term financial needs? Established firms have several sources of short-term funds: bank loans (can be extended with good credit), trade credit (when suppliers ship materials to a firm on credit), factoring (provide immediate cash to firms by purchasing their accounts receivable at a discount), & commercial paper (short-term IOUs). Equity financing (funds provided by owners) and long-term debt financing can be done by firms to build up their permanent financial base.
How do financial managers determine the firm’s capital structure? Debt financing enables firm to finance activities without requiring owners to put up more money. When firm earns more on borrowed funds than it pays in interest, excess goes to the owners which magnifies return on the investment. Interest payments on debt are tax deductible. Equity financing is safer and more flexible than debt financing.
How do financial managers acquire and manage current assets? Firms must have cash, but cash earns little to no interest but can do other things with cash to earn more interest (T-bills, commercial paper, and money market mutual funds). Accounts receivable are what customers who buy on credit owe to a firm, and firms must establish credit policies to ensure that credit customers will make their payments (or so they make a profit from this). Inventories are stocks of materials, work in process, and finished goods a firm holds, and cost of storing and handling inventory items can be significant so these are kept as low as possible.
How do financial managers evaluate capital budgeting proposals? Time value of money recognizes that sooner the cash is received, the sooner it can be reinvested to earn more money. Financial managers take time value of money into account by computing the present values of all cash flows the proposal will generate. Present value of a sum of money received in the future is the amount of money today that will become that future amount if it is invested at a specified rate of interest. Net present value (NPV) is sum of present values of all the estimated future cash flows, minus the initial cost of the investment.

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