Understanding Financial Management and Securities Markets
138 How Organizations Use Funds
- What types of short-term and long-term expenditures does a firm make?
To grow and prosper, a firm must keep investing money in its operations. The financial manager decides how best to use the firm’s money. Short-term expenses support the firm’s day-to-day activities. For instance, athletic-apparel maker Nike regularly spends money to buy such raw materials as leather and fabric and to pay employee salaries. Long-term expenses are typically for fixed assets. For Nike, these would include outlays to build a new factory, buy automated manufacturing equipment, or acquire a small manufacturer of sports apparel.
Short-term expenses, often called operating expenses, are outlays used to support current production and selling activities. They typically result in current assets, which include cash and any other assets (accounts receivable and inventory) that can be converted to cash within a year. The financial manager’s goal is to manage current assets so the firm has enough cash to pay its bills and to support its accounts receivable and inventory.
Cash Management: Assuring Liquidity
Cash is the lifeblood of business. Without it, a firm could not operate. An important duty of the financial manager is cash management, or making sure that enough cash is on hand to pay bills as they come due and to meet unexpected expenses.
Businesses estimate their cash requirements for a specific period. Many companies keep a minimum cash balance to cover unexpected expenses or changes in projected cash flows. The financial manager arranges loans to cover any shortfalls. If the size and timing of cash inflows closely match the size and timing of cash outflows, the company needs to keep only a small amount of cash on hand. A company whose sales and receipts are fairly predictable and regular throughout the year needs less cash than a company with a seasonal pattern of sales and receipts. A toy company, for instance, whose sales are concentrated in the fall, spends a great deal of cash during the spring and summer to build inventory. It has excess cash during the winter and early spring, when it collects on sales from its peak selling season.
Because cash held in checking accounts earns little, if any, interest, the financial manager tries to keep cash balances low and to invest the surplus cash. Surpluses are invested temporarily in marketable securities, short-term investments that are easily converted into cash. The financial manager looks for low-risk investments that offer high returns. Three of the most popular marketable securities are Treasury bills, certificates of deposit, and commercial paper. (Commercial paper is unsecured short-term debt—an IOU—issued by a financially strong corporation.) Today’s financial managers have new tools to help them find the best short-term investments, such as online trading platforms that save time and provide access to more types of investments. These have been especially useful for smaller companies who don’t have large finance staffs.
Companies with overseas operations face even greater cash management challenges. Developing the systems for international cash management may sound simple in theory, but in practice it’s extremely complex. In addition to dealing with multiple foreign currencies, treasurers must understand and follow banking practices and regulatory and tax requirements in each country. Regulations may impede their ability to move funds freely across borders. Also, issuing a standard set of procedures for every office may not work because local business practices differ from country to country. In addition, local managers may resist the shift to a centralized structure because they don’t want to give up control of cash generated by their units. Corporate financial managers must be sensitive to and aware of local customs and adapt the centralization strategy accordingly.
In addition to seeking the right balance between cash and marketable securities, the financial manager tries to shorten the time between the purchase of inventory or services (cash outflows) and the collection of cash from sales (cash inflows). The three key strategies are to collect money owed to the firm (accounts receivable) as quickly as possible, to pay money owed to others (accounts payable) as late as possible without damaging the firm’s credit reputation, and to minimize the funds tied up in inventory.
Managing Accounts Receivable
Accounts receivable represent sales for which the firm has not yet been paid. Because the product has been sold but cash has not yet been received, an account receivable amounts to a use of funds. For the average manufacturing firm, accounts receivable represent about 15 to 20 percent of total assets.
The financial manager’s goal is to collect money owed to the firm as quickly as possible, while offering customers credit terms attractive enough to increase sales. Accounts receivable management involves setting credit policies, guidelines on offering credit, credit terms, and specific repayment conditions, including how long customers have to pay their bills and whether a cash discount is given for quicker payment. Another aspect of accounts receivable management is deciding on collection policies, the procedures for collecting overdue accounts.
Setting up credit and collection policies is a balancing act for financial managers. On the one hand, easier credit policies or generous credit terms (a longer repayment period or larger cash discount) result in increased sales. On the other hand, the firm has to finance more accounts receivable. The risk of uncollectible accounts receivable also rises. Businesses consider the impact on sales, timing of cash flow, experience with bad debt, customer profiles, and industry standards when developing their credit and collection policies.
Companies that want to speed up collections actively manage their accounts receivable, rather than passively letting customers pay when they want to. According to recent statistics, more than 90 percent of businesses experience late payments from customers, and some companies write off a percentage of their bad debt, which can be expensive.
Technology plays a big role in helping companies improve their credit and collections performance. For example, many companies use some type of automated decision-making, whether that comes in the form of an ERP system or a combination of software programs and supplemental modules that help companies make informed decisions when it comes to credit and collection processes.
Other companies choose to outsource financial and accounting business processes to specialists rather than develop their own systems. The availability of cutting-edge technology and specialized electronic platforms that would be difficult and expensive to develop in-house is winning over firms of all sizes. Giving up control of finance to a third party has not been easy for CFOs. The risks are high when financial and other sensitive corporate data are transferred to an outside computer system: data could be compromised or lost, or rivals could steal corporate data. It’s also harder to monitor an outside provider than your own employees. One outsourcing area that has attracted many clients is international trade, which has regulations that differ from country to country and requires huge amounts of documentation. With specialized IT systems, providers can track not only the physical location of goods, but also all the paperwork associated with shipments. Processing costs for goods purchased overseas are about twice those of domestic goods, so more efficient systems pay off.
Another use of funds is to buy inventory needed by the firm. In a typical manufacturing firm, inventory is nearly 20 percent of total assets. The cost of inventory includes not only its purchase price, but also ordering, handling, storage, interest, and insurance costs.
Production, marketing, and finance managers usually have differing views about inventory. Production managers want lots of raw materials on hand to avoid production delays. Marketing managers want lots of finished goods on hand so customer orders can be filled quickly. But financial managers want the least inventory possible without harming production efficiency or sales. Financial managers must work closely with production and marketing to balance these conflicting goals. Techniques for reducing the investment in inventory are inventory management, the just-in-time system, and materials requirement planning.
For retail firms, inventory management is a critical area for financial managers, who closely monitor inventory turnover ratios. This ratio shows how quickly inventory moves through the firm and is turned into sales. If the inventory number is too high, it will typically affect the amount of working capital a company has on hand, forcing the company to borrow money to cover the excess inventory. If the turnover ratio number is too high, it means the company does not have enough inventory of products on hand to satisfy customer needs, which means they could take their business elsewhere.
A firm also invests funds in physical assets such as land, buildings, machinery, equipment, and information systems. These are called capital expenditures. Unlike operating expenses, which produce benefits within a year, the benefits from capital expenditures extend beyond one year. For instance, a printer’s purchase of a new printing press with a usable life of seven years is a capital expenditure and appears as a fixed asset on the firm’s balance sheet. Paper, ink, and other supplies, however, are expenses. Mergers and acquisitions are also considered capital expenditures.
Firms make capital expenditures for many reasons. The most common are to expand, to replace or renew fixed assets, and to develop new products. Most manufacturing firms have a big investment in long-term assets. Boeing Company, for instance, puts billions of dollars a year into airplane-manufacturing facilities. Because capital expenditures tend to be costly and have a major effect on the firm’s future, the financial manager uses a process called capital budgeting to analyze long-term projects and select those that offer the best returns while maximizing the firm’s value. Decisions involving new products or the acquisition of another business are especially important. Managers look at project costs and forecast the future benefits the project will bring to calculate the firm’s estimated return on the investment.
- Distinguish between short- and long-term expenses.
- What is the financial manager’s goal in cash management? List the three key cash management strategies.
- Describe a firm’s main motives in making capital expenditures.
Summary of Learning Outcomes
- What types of short-term and long-term expenditures does a firm make?
A firm incurs short-term expenses—supplies, inventory, and wages—to support current production, marketing, and sales activities. The financial manager manages the firm’s investment in current assets so that the company has enough cash to pay its bills and support accounts receivable and inventory. Long-term expenditures (capital expenditures) are made for fixed assets such as land, buildings, equipment and information systems. Because of the large outlays required for capital expenditures, financial managers carefully analyze proposed projects to determine which offer the best returns.
- accounts receivable
- Sales for which a firm has not yet been paid.
- capital budgeting
- The process of analyzing long-term projects and selecting those that offer the best returns while maximizing the firm’s value.
- capital expenditures
- Investments in long-lived assets, such as land, buildings, machinery, equipment, and information services, that are expected to provide benefits over a period longer than one year.
- cash management
- The process of making sure that a firm has enough cash on hand to pay bills as they come due and to meet unexpected expenses.
- commercial paper
- Unsecured short-term debt—an IOU—issued by a financially strong corporation.
- marketable securities
- Short-term investments that are easily converted into cash.