Chapter 20

Imagine using your cell phone to open a bank account! The financial services industry is indeed moving in new directions, as demonstrated by Citigroup. Advanced technology, globalization of markets, and the relaxation of regulatory restrictions are accelerating the pace of change in financial services. The changes are giving businesses and consumers new options for conducting their financial transactions. The competitive landscape for financial institutions is also changing as they develop new ways to increase their market share and boost profits.

Because financial institutions connect people with money, this chapter begins with a discussion of money, its characteristics and functions, and the components of the U.S. money supply. Next it explains the role of the Federal Reserve System in managing the money supply. Then it describes different types of financial institutions and their services and the organizations that insure customer deposits. The chapter ends with a discussion of international banking and trends in the banking industry.

Money is anything that is acceptable as payment for goods and services. It affects our lives in many ways. We earn it, spend it, save it, invest it—and often wish we had more of it. Business and government use money in similar ways. Both require money to finance their operations. By controlling the amount of money in circulation, the federal government can promote economic growth and stability. For this reason, money has been called the lubricant for the machinery of our economic system. Our banking system was developed to ease the handling of money.

For money to be suitable means of exchange, it should have these key characteristics:

not so scarce as to be unavailable. Pebbles, which meet some of the other criteria, would not work well as money because they are widely available. Too much money in circulation increases price (inflation, as discussed in Chapter 2). Governments control the scarcity of money by limiting the quantity of money produced.

item such as a banana becomes useless as money when it spoils. Even early societies used durable forms of money, such as metal coins and paper money, that lasted for a long time.

items, such as boulders or heavy gold bars, cannot be transported easily from place to place.

parts. Divisible forms of money help make possible transactions of all sizes and amounts.

Using several types of goods as money would be confusing. Thus, societies develop a uniform money system to measure the value of goods and services. For money to be acceptable, it must function as a medium of exchange, as a standard of value, and as a store of goods.

As a medium of exchange, money makes transactions easier. Having a common form of payment in each country is much less complicated than having a barter system—where goods and services are exchanged for other goods and services. Money allows the exchange of products to be a simple process.

Money also serves as a store of value. With a form of money whose value is accepted by all, goods and services can be priced in standard units. This makes it easy to measure the value of products and allows transactions to be recorded in consistent terms.

As a store of value, money is used to hold wealth. It retains its value over time. Someone who owns money can keep it for future use rather than exchange it today for other types of assets.

The U.S. money supply has three parts: currency, demand deposits, and time deposits.

Currency is cash held in the form of coins and paper money. Other forms of currency are traveler’s checks, cashier’s checks, and money orders. As of October 2000, the United States had about $524 billion of currency in circulation.

Demand deposits consist of money kept in checking accounts that can be withdrawn by depositors on demand. As of October 2000, U.S. demand deposits totaled $324 billion. Demand deposits include regular checking accounts as well as interest-bearing and other special types of checking accounts.

Time deposits are deposits at a bank or other financial institutions that pay interest but cannot be withdrawn on demand. Examples are savings accounts, money market deposit accounts, and certificates of deposit. Time deposits are totaled about $3.8 trillion as of October 2000.

Credit cards, sometimes referred to as “plastic money,” are used as a substitute for cash and checks. Credit cards are simply a form of borrowing. When Citigroup issues a credit card to a small business owner, it gives a short-term loan to the business by directly paying the seller for the business’s purchases. The business pays Citigroup when it receives its monthly statement.

Before the twentieth century, there was very little government regulation of the U.S. financial system. For most of its history, the country’s banking system was decentralized because the public was afraid that a huge central bank would negatively affect the financial system.

In 1907 several large banks failed. These failures caused a public panic that resulted in a run on other banks by depositors who wanted to withdraw their money. This caused cash shortages and resulted in the failure of many other banks. The Panic of 1907 was so severe that Congress had to act. In 1913 it created the Federal Reserve System (commonly called the Fed) to correct weaknesses of the U.S. financial system.

The Federal Reserve System is the central bank of the United States. It consists of 12 district banks, each located in a major U.S. city. Originally, the Federal Reserve System was created to control the money supply, act as a borrowing source for banks, hold the deposits of member banks, and supervise banking practices. Its activities have since broadened, making it the most powerful financial institution in the United States. Today, four of the Federal Reserve System’s major activities are carrying out monetary policy, setting rules on credit, distributing currency, and making check clearing easier.

The most important function of the Federal Reserve System is carrying out monetary policy. It uses its power to change the money supply in order to control inflation and interest rates, increase employment, and influence economic activity. Three tools used by the Federal Reserve System in managing the money supply are open market operations, reserve requirements, and the discount rate. Exhibit 20-1 summarizes the short-term effects of these tools on the economy.

Effect on Effect on Effect on

Tool Action Money Supply Interest Rates Economic Activity

Open market Buy Increases Lowers Stimulates

operations government

bonds

Sell Decreases Raises Slows down

government

bonds

Reserve Raise Decreases Raises Slows down

Requirements reserve

requirements

Lower Increases Lowers Stimulates

reserve

requirements

Discount Rate Raise Decreases Raises Slows down

discount rate

Lower Increases Lowers Stimulates

discount rate

Open market operations—the tool most frequently used by the Federal Reserve—involve the purchase or sale of U.S. governmental bonds. The U.S. Treasury issues bonds to obtain the extra money needed to run the government (if taxes and other revenues aren’t enough). In effect, Treasury bonds are long-term loans (five years or longer) made by businesses and individuals to the government. The Federal Reserve buys and sells these bonds for the Treasury. When the Federal Reserve buys bonds, it puts money into the economy. Banks have more money to lend sot they reduce interest rates, and lower rates generally stimulate economic activity. The opposite occurs when the Federal Reserve sells government bonds.

Banks that are members of the Federal Reserve System must hold some of their deposits in cash in their vaults or in an account at a district bank. This reserve requirement ranges from 3 to 10 percent on different types of deposits. When the Federal Reserve raises the reserve requirement, banks must hold larger reserves and thus have less money to lend. As a result, interest rates rise and economic activity slows down. Lowering the reserve requirement increases loanable funds, causes banks to lower interest rates, and stimulates the economy. The Federal Reserve seldom changes reserve requirements, however.

The Federal Reserve is called the “banker’s bank” because it lends money to banks that need it. The interest rate that the Federal Reserve charges its member banks is called the discount rate. When the discount rate is less than the cost of other sources of funds (such as certificates of deposit), commercial banks borrow from the Federal Reserve and then lend the funds at a higher rate to customers. The banks profit from the spread, or difference, between the rate they charge their customers and the rate paid to the Federal Reserve. Changes in the discount rate usually produce changes in the interest rate that banks charge their customers. The Federal Reserve raises the discount rate to slow down economic growth and lowers it to stimulate growth.

Another activity of the Federal Reserve System is setting rules on credit. It controls the credit terms on some loans made by banks and other lending institutions. This power, called selective credit controls, includes consumer credit rules and margin requirements.

Consumer credit rules establish the minimum down payments and maximum repayment periods for consumer loans. The Federal Reserve uses credit rules to slow or stimulate consumer credit purchases.

Margin requirements specify the minimum amount of cash an investor must pay up to buy securities—investment certificates issued by corporations or governments. The balance of the purchase cost can be financed through borrowing from a bank or brokerage firm. By lowering the margin requirements, the Federal Reserve stimulates securities trading. Raising the margin requirement slows the trading. Margin requirements are discussed further in Chapter 22.

The Federal Reserve distributes to banks the coins minted and the paper money printed by the U.S. Treasury. Most paper money is in the form of Federal Reserve notes. Look at a dollar bill and you’ll see “Federal Reserve Note” at the top. The large letter seal on the left indicates which Federal Reserve Bank issued it. For example, bills bearing a D seal are issued by the Federal Reserve Bank of Cleveland, and those with an L seal are issued by the San Francisco district bank.

Another important activity of the Federal Reserve is helping banks and other financial institutions clear checks. It handles about 18 billion checks a year. Its check-clearing system lets banks quickly convert checks drawn on other banks—even distant ones—into cash. Checks drawn on banks within the same Federal Reserve district are handled locally and reported to the Federal Reserve, which uses a series of bookkeeping entries to transfer funds between the banks. The process is more complex for checks drawn on banks outside a bank’s Federal Reserve district.

The time between when the check is written and when the funds are deducted from the check writer’s account provides float. Float benefits the check writer by allowing it to retain the funds until the check clears, i.e., the funds are actually withdrawn from its accounts. Businesses open accounts at banks throughout the country that are know to have long check-clearing times. By “playing the float,” firms can keep their funds invested for several extra days, thus earning more money. To reduce this practice, in 1988 the Fed established maximum check-clearing times.

The well-developed financial system in the United States supports our high standard of living. The system allows those who wish to borrow money to do so with relative ease. It also gives savers a variety of ways to earn interest on their savings. For example, a computer company that wants to build a new headquarters in Atlanta might be financed partly with the savings of families in California. The Californians deposit their money in a local financial institution. That institution looks for a profitable and safe way to use the money and decides to make a real estate loan to the computer company. The transfer of funds from savers to investors enables businesses to expand and the economy to grow.

Households are important participants in the U.S. financial system. Although many households borrow money to finance purchases, they supply funds to the financial system through their purchases and savings. Overall, businesses and governments are users of funds. They borrow more money than they save.

Sometimes those who have funds deal directly with those who want them. A wealthy realtor, for example, may lend money to a client to buy a house. But most often, financial institutions act as intermediaries—or go-betweens—between the suppliers and demanders of funds. The institutions accept savers’ deposits and invest them in financial products (such as loans) that are expected to produce a return.

This process, called financial intermediation, is shown in Exhibit 20-2, page 605. Households are shown as suppliers of funds, and businesses and governments are shown as demanders. But a single household, business, or government can either be a supplier or a demander, depending on the circumstances.

Financial institutions are the heart of the financial system. They are a convenient vehicle for financial intermediation. They can be divided into two broad groups: depository institutions (those that accept deposits) and nondepository institutions (those that do not accept deposits).

Not all depository financial institutions are alike. Most people call the place where they save their money a “bank.” Some of those places are indeed banks, but other depository institutions include thrift institutions and credit unions.

A commercial bank is a profit-oriented financial institution that accepts deposits, makes business and consumer loans, invests in government and corporate securities, and provides other financial services. There are about 8,500 commercial banks in the United States accounting for $6 trillion in loans and investments (a bank’s assets) and $3.8 trillion in deposits. Exhibit 20-3, page 606, lists the top 10 U.S. commercial banks.

Customers’ deposits are a commercial bank’s main source of funds; the main use of those funds is loans. The difference between the interest earned on loans and the interest paid on deposits, plus fees earned from other financial services, pays the bank’s costs and provides a profit. Commercial banks are corporations owned and operated by individuals or other corporations.

To do business, they must get a bank charter—an operating license—from either the federal government or a state government. Thus U.S. commercial banks can be either national or state banks.

National banks are chartered by the Comptroller of the Currency, who is part of the U.S. Treasury Department. These banks must belong to the Federal Reserve System and must carry insurance on their deposits from the Federal Deposit Insurance Corporation.

State banks are chartered by the state in which they are based. Generally, state banks are smaller than national banks, are less closely regulated than national banks, and are not required to belong to the Federal Reserve System.

A thrift institution is a depository institution formed specifically to encourage household saving and to make home mortgage loans.

Thrift institutions include savings and loans associations (S&Ls) and savings banks. S&Ls keep large percentages of their assets in home mortgages. Compared with S&Ls, savings banks focus less on mortgage loans and more on stock and bond investments. The 1,630 thrift institutions in the United States have about $1.1 trillion in assets and $712 billion in deposits.

A credit union is a not-for-profit, member-owned financial cooperative. Credit union members typically have something in common—their employer, union, professional group, or church, for example. The not-for-profit status of credit unions make them tax-exempt, so they can pay good interest rates on deposits and offer loans at favorable interest rates. The approximately 12,000 credit unions in the United States have more than 75 million members. Credit union assets total almost $400 billion.

Some financial institutions provide a few banking services but do not accept deposits. These nondepository financial institutions include insurance companies, pension funds, brokerage firms, and finance companies. They serve both individuals and businesses.

Insurance companies are major suppliers of funds. Policyholders make payments (called premiums) to buy financial protection from the insurance company. Insurance companies invest the premiums in stocks, bonds, real estate, business loans, and real estate loans for large projects. The insurance industry is discussed in detail in the Appendix to Chapter 23, Managing Risk and Insurance.

Corporations, unions, and governments set aside large pools of money for later use in paying retirement benefits to their employees or members. These pension funds are managed by the employers or unions themselves or by outside managers, such as life insurance firms, commercial banks, and private investment firms. Pension plan members receive a specified monthly payment when they reach a given age. After setting aside enough money to pay near-term benefits, pension funds invest the rest in business loans, stock, bonds, or real estate. They often invest large sums in the stock of the employer. Pension fund assets total almost $4 trillion.

A brokerage firm buys and sells securities (stocks and bonds) for its clients and gives them related advice. Many brokerage firms offer some banking services. They may offer clients a combined checking and savings account with a high interest rate and also make loans, backed by securities, to them. Chapter 22 explains the activities of brokerage firms in more detail.

A finance company makes short-term loans for which the borrower puts up tangible assets (such as automobile, inventory, machinery, or property) as security. Finance companies often make loans to individuals or businesses that cannot get credit elsewhere. To compensate for the extra risk, finance companies usually charge higher interest rates than banks do.

Consumer finance companies make loans to individuals. Beneficial Corp. and Household International, which recently merged, are two of the largest consumer finance companies. Together, they have more than 30 million customers.

Promising new businesses with no track record and firms that can’t get more credit from a bank often obtain loans from commercial finance companies. AT&T Capital Business Finance, GE Capital Small Business Finance, and The Money Store Commercial Lending are examples of commercial finance companies.

The U.S. banking system worked fairly well from the establishment of the Federal Reserve System in 1913 until the 1929 stock market crash and the Great Depression that followed. Business failures caused by these events resulted in major cash shortages as people rushed to withdraw their money from banks. Many cash-starved banks failed because the Federal Reserve did not, as expected, lend money to them. The government’s efforts to prevent bank failures were ineffective. In the next two years, 5,000 banks—about 20 percent of the total number—failed.

President Franklin D. Roosevelt made strengthening the banking system his first priority. After taking office in 1933, Roosevelt declared a bank holiday, closing all banks for a week so he could take corrective actions. Congress passed the Banking Act of 1933, which gave the Federal Reserve System power to regulate banks and reform the banking system.

The act’s most important provision was the creation of the Federal Deposit Insurance Corporation (FDIC) to insure deposits in commercial banks. The 1933 act also gave the Federal Reserve the authority to set reserve requirements, ban interest on demand deposits, regulate the interest rates on time deposits, and prohibit banks from investing in specified types of securities. In 1934 the Federal Savings and Loan Insurance Corporation (FSLIC) was formed to insure deposits at S&Ls. When the FSLIC went bankrupt in the 1980s, the FDIC took responsibility for administering the fund that insures deposits at thrift institutions. Today, the major deposit insurance funds include the following:

by the National Credit Union Administration, this fund provides deposit insurance to credit unions.

The FDIC is an independent, quasi-public corporation backed by the full faith and credit of the U.S. government. It insures about 314 million deposit accounts in commercial banks and 79 million accounts in thrift institutions against loss if the financial institution fails. All member banks in the Federal Reserve System must be insured by the FDIC.

The ceiling on insured deposits is $100,000 per account. Each insured bank pays the insurance premiums, which are a fixed percentage of the bank’s domestic deposits….

To ensure that banks operate fairly and profitably, the FDIC sets guidelines for banks and then reviews the financial records and management practices of member banks at least once a year. These reviews are performed by bank examiners, whose visits are unannounced. Bank examiners rate banks on their compliance with banking regulations. For example, banks must comply with the Equal Credit Opportunity Act, which states that a bank cannot refuse to lend money to people because their color, religion, or national origin. Examiners also rate a bank’s overall financial condition. They focus on loan quality, management practices, earnings, liquidity, and whether the bank has enough capital (equity) to safely support its activities….

The financial marketplace spans the globe, with money routinely flowing across international boarders. Multinational corporations need many special banking services, such as foreign currency exchange. Many U.S. banks started expanding into overseas markets by operating offices in Europe, Latin America, and the Far East. They provided better customer service than local banks in many countries and had access to more sources of funding. Citibank, for example, was the first bank in Japan to offer banking-by-phone and 24-hour-a-day ATM service. These services have helped Citibank earn a reputation as the most innovative bank in Japan.

Competing against foreign banks can be difficult. Foreign banks are subject to fewer regulations, making it easier for them to undercut U.S. banks on the pricing of loans and services to multinational corporations and governments. Some governments protect their banks against foreign banks from acquiring domestic banks, which are mostly family-owned businesses. Until recently, Singapore limited foreign ownership to 40 percent. By eliminating that restriction and permitting a limited number of foreign banks to open branches in Singapore and to install ATMs, the government is allowing more competition from foreign banks….

Once a highly regulated industry offering limited services, the banking industry continues to change. Trends influencing the direction of banking are online banking, consolidation, and the integration of banking with brokerage and insurance services.

Banks are using Internet technology to expand their services. A research study from International Data Corp. predicts that about 23 million U.S. households will bank online by 2004, up from 10.5 million households in 1999. “Online banking may be the critical service that enables banks to maintain their role as the dominant provider of financial services,” says Paul Johnson, an analyst with International Data….

The number of depository institutions declined more than 40 percent over the past 25 years, falling from almost 19,000 in 1975 to less than 9,000 today. Although part of the decline can be attributed to the failure of banks and thrift institutions, most of it was due to consolidation through mergers and acquisitions. Mergers increased substantially during the 1990s, with many banks acquiring local competitors to increase their market share within a region. In 1996 alone, more than 360 banks merged to create a nationwide customer base….

As mentioned in the opening vignette, The Financial Services Modernization Act passed in November 1999, repealed the Glass-Steagall Act of 1933, which prohibited banks from selling securities and insurance. Glass-Steagall was passed after federal investigations of bank failures following the 1929 stock market crash indicated that banks’ practice of buying stock in their customers’ firms had contributed to the failures. Banks argued that the law was outdated and put them at a disadvantage in competing with security and investment firms, which are not bound by the same laws that regulated banks.

The Financial Modernization Act now allows banks, such as Citigroup, to sell securities and insurance products. Industry experts at the time of its passage, correctly predicted that the Act would result in a new wave of mergers and acquisitions between commercial banks and brokerage and insurance firms. This bank reform benefits consumers by allowing them to structure their financial planning with one financial intermediary rather than using separate firms for their banking, investment, and insurance needs.

The bank you use today is vastly different from the bank your parents used 30 years ago. And the bank you will use in 2030 will be far different from your bank today. Because technology is driving many of the changes in banking, expect to use your computer and innovations like smart cards to conduct your financial transactions. Soon you may be getting your telephone bill via your computer rather than your mailbox. Because technology-based banking options are cheaper for banks, you’ll see more promotions like the Citigroup ad whose headline proclaims “Pay 2 bills online. Get $25.” As banks introduce new ways to deliver their product and services, the prediction of a cashless, checkless society is becoming a reality.

New bank products and services mean consumers have many more choices. You can choose the convenience of online banking or opt for a more personal banking relationship at a community bank. Especially if you are an entrepreneur or a small business owner, you’ll want to build a personal relationship with your banker.

Here’s what you’ll need to bank online. If you’re going online through the World Wide Web, you’ll need a computer with Internet capability—one with a 56.6 bps modem or high-speed Web access, a Web browser, and service from an Internet or online service provider. Most providers charge about $20 per month for unlimited use. If you don’t want to pay for Internet access or are concerned about the security of your transactions, you can get special software from your bank that connects you to the bank through a dial-in line. Most banks don’t charge customers for the software. But online service fee vary among banks, so visit the Web sites of several banks to compare their fees and the services they offer.

Entrepreneurs and small businesses have a more difficult time obtaining credit from a bank than do large firms that have proven track records and large asset bases. The best way to improve you chances of getting a business loan is to give the bank information that can help it understand the strengths of your business. Prospective bankers are impressed by well-prepared presentations that include your business plan, financial history, and a management team that is committed to helping you achieve your goals.

When investigating banks, entrepreneurs and small business owners need to look at banks as more than just lending institutions. They need to ask what bank services and products can help them improve their efficiency and profitability. They should describe the type of relationship they want with their banker and the kinds of loans they’ll need and the terms of payment they expect.

money to be a suitable means of exchange, it should be scarce, durable, portable, and divisible. Money functions as a medium of exchange, a standard of value, and a store of value. The U.S. money supply consists of currency (coins and paper money), demand deposits (checking accounts), and time deposits (interest-bearing deposits that cannot be withdrawn on demand).

agency that performs four main functions: carrying out monetary policy, setting rules on credit, distributing currency, and making check clearing easier. The three tools it uses in managing the money supply are open market operations, reserve requirements, and the discount rate.

institutions and nondepository institutions. Depository institutions include commercial banks, thrift institutions, and credit unions. Nondepository institutions include insurance companies, pension funds, brokerage firms, and finance companies. Financial institutions ease the transfer of funds between suppliers and demanders.

The Federal Deposit Insurance Corporation insures deposits in commercial banks through the Bank Insurance Fund and deposits in thrift institutions through the Savings Association Insurance Fund. The FDIC sets banking policies and practices and reviews banks annually to ensure that they operate fairly and profitably.

governments and businesses. They also offer specialized services such as cash management and foreign currency exchange.

By using Internet technology, banks are delivering more services online. Bank mergers and acquisitions continue to consolidate the banking industry, helping banks to improve their operating efficiency, reduce costs, and extend their geographic reach. Recent passage of bank reform legislation that allows banks to market securities and insurance products will help banks compete with nondepository institutions and with banks in other countries.

In today’s fast-paced global economy, managing a firm’s finances is more complex than ever. For managers like Larry Kellner, a thorough command of traditional finance activities—financial planning, investing money, and raising funds—is only part of the job. Financial managers are more than number crunchers. As part of the top management team, chief financial officers (CFOs) need a broad understanding of their firm’s business and industry, as well as leadership ability and creativity. The must never lose sight of the primary goal of the financial manager: to maximize the value of the firm to its owners.

Financial management—raising and spending a firm’s money—is both a science and an art. The science part is analyzing numbers and flows of cash through the firm. The art is answering questions like these: Is the firm using its financial resources in the best way? Aside from costs, why choose a particular form of financing? How risky is each option?

This chapter focuses on the financial management of a firm. We’ll start with an overview of the role of finance and of the financial manager in the firm’s overall business strategy. Next we consider the basics of financial planning—forecasts and budgets. Discussions of investment decisions and sources of short and long-term financing follow. Finally, we’ll look at key trends affecting financial management in the 21^st century.

Finance is critical to the success of all companies. It may not be as visible as marketing or production, but management of a firm’s finances is just as much a key to its success.

Financial management—the art and science of managing a firm’s money so it can meet its goals—is not just the responsibility of the finance department. All business discussions have financial consequences. Managers in all departments must work closely with financial personnel. If you are a sales representative, for example, the company’s credit and collection policies will affect your ability to make sales.

Any company, whether it’s a two-attorney law partnership or General Motors, needs money to operate. To make money, it must first spend money—on inventory and supplies, equipment and facilities, and employee wages and salaries.

Revenues from sales of the firm’s products should be the chief source of funding. But money from sales doesn’t always come in when it’s needed to pay the bills. Financial managers must track how money is flowing into and out of the firm (see Exhibit 21, page 623). They work with the firm’s other department managers to determine how available funds will be used and how much money is needed. Then they choose the best sources to obtain the required funding….

Financial management is closely related to accounting. In most firms both areas are the responsibility of the vice-president of finance or the CFO. But accountants’ main function is to collect and present financial data. Financial managers use financial statements and other information prepared by accountants to make financial decisions.

Financial managers focus on cash flows, the inflow and outflow of cash. They plan and monitor the firm’s cash flows to ensure that cash is available when needed.

Financial managers have a complex and challenging job. They analyze financial data prepared by accountants, monitor the firm’s financial status, and prepare and implement financial plans. One day they may be developing a better way to automate cash collections, the next they may be analyzing a proposed acquisition. The key activities of the financial manager are:

operations and investments and seeking the best balance between debt (borrowed funds) and equity (funds raised through the sale of ownership shares in the business).

How can financial managers make wise planning, investment, and financing decisions? The main goal of the financial manager is to maximize the value of the firm to its owners. The value of a publicly owned corporation is measured by the share price of its stock. A private company’s value is the price at which it could be sold.

To maximize the firm’s value, the financial manager has to consider both short- and long-term consequences of the firm’s actions. Maximizing profits is one approach, but it should not be only one. Such an approach favors making short-term gains over achieving long-term goals. What if a firm in a highly technical and competitive industry did no research and development? In the short run, profits would be high because research and development is very expensive. But in the long-run, the firm might lose its ability to compete because of its lack of new products.

Financial managers constantly strive for a balance between the opportunity for profit and the potential for loss.

the potential for loss, or the chance that an investment will not achieve the expected level of return is risk

A basic principle in finance is that the higher the risk, the greater the return that is required. This widely accepted concept is called the risk-return trade-off. Financial managers consider many risk and return factors when making investment and financing decisions. Among them are changing patterns of market demand, interest rates, general economic conditions, market conditions, and social issues (such as environmental effects and equal employment opportunity polices).

As we learned in Chapter 7, companies use several types of plans to determine how to achieve organizational objectives. A company’s financial plan is part of the overall company plan and guides the firm toward its business goals and the maximization of its value. The financial plan enables the firm to estimate the amount and timing of its investment and financing needs.

To prepare a financial plan, the financial manager must first consider existing and proposed products, the resources available to produce them, and the financing needed to support production and sales. Forecasts and budgets are essential to the firm’s financial planning. They should be part of an integrated planning process that links them to strategic plans and performance measurement.

The financial planning process starts with financial forecasts, or projections of future developments with the firm. The estimated demand for the firm’s products (the sales forecast) and other financial and operating data are key inputs. At Ford Motor Company, economic analysts estimate expected production and sales for each line of cars and trucks. Then financial analysts prepare detailed short- and long-term financial forecasts based on these assumptions.

Short-term forecasts, or operating plans, project revenues, costs of goods, and operating expenses over a one-year period. Using short-term forecasts, Ford’s financial managers estimate the next year’s expenses for inventory, labor, advertising, and other operating activities. These estimates form the basis for cash budgets, described below, which forecast cash inflows and outflows over the same period.

Long-term forecasts, or strategic plans, typically cover 2 to 10 years and take a broader view of the firm’s financial activities. With these forecasts, management can assess the financial effects of various business strategies: What would be the financial results of investing in new facilities and equipment? Of developing new products? Of eliminating a line of business? Of acquiring other firms? Long-term forecasts also show where the funding for these activities is expected to come from.

Firms prepare budgets to plan and control their future financial activities. These are formal written forecasts of revenues and expenses that set spending limits based on operational forecasts. All budgets begin with forecasts. Budgets are a way to control expenses and compare the actual performance to the forecast.

Firms use several types of budgets. Most cover a one-year period. Cash budgets forecast the firm’s cash inflows and outflows and help the firm plan for cash surpluses and shortages. Because having enough cash is so critical to their financial health, many firms prepare annual cash budgets subdivided into months or weeks. Then they project the amount of cash needed in each shorter time period.

Capital budgets forecast outlays for fixed expenses (plant and equipment). They usually cover a period of several years and ensure that the firm will have enough funds to buy the equipment and buildings it needs.

Operating budgets combine sales forecasts with estimates of production costs and operating expenses in order to forecast profits. They are based on individual budgets for sales, production, purchases of materials, factory overhead, and operating expenses. Operating budgets then are used to plan operations: dollars of sales, units of production, amounts of raw materials, dollars of wages, and so forth.

Budgets are routinely used to monitor and control the performance of a division, a department, or an individual manager. When actual outcomes differ from budget expectations, management must take action.

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.

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 use budgets to estimate the cash requirements for a specific period. Many companies keep a minimum cash balance to cover unexpected expenses or to cover 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 balances low and to invest the surplus cash. Surpluses are invested temporarily in marketable securities, short-term 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.)

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, and credit terms, 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 can use several strategies. They can actively manager their accounts receivable, rather than passively letting customers pay when they want to. Michael Churchman, owner of Rocky Mountain Radar, an electronics company in El Paso, Texas, waited three months for his first payment from the federal government. Not content to settle for the government’s typically slow payment process, he took steps to be paid in 15 days: good follow-up with both the buyer and the person who handles his accounts payable and offering a 5 percent cash discount for payment within 15 days. The benefits of faster collections offset the small discount.

Technology can also help firms speed up collections. To cope with the meteoric rise in sales and, hence, accounts receivable, Dell computer implemented an automated receivables collection system. Customized software improved order processing and collection methods. The new system also took over labor intensive tasks such as sending letters to overdue accounts at specified times and creating activity reports with current account status. Dell’s days receivables outstanding dropped from 50 to 37 days, freeing up a significant amount of cash.

Another use of funds is to buy inventory needed by the firm. In a typical manufacturing firm, inventory is nearly 20 percent of the 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 different 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—efficient order quantities, the just-in-time system, and materials requirement planning—were described in Chapter 12.

A firm also uses funds for its investments in long-lived assets, such items as land, buildings, machinery, and equipment. 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 useable life of seven years is a capital expenditure. It appears as a fixed asset on the firm’s balance sheet. Paper, ink, and other supplies, however, are expenses. Mergers and acquisitions, discussed in Chapter 5, are also considered capital expenditures.

Firms make capital expenditures for many reasons. The most common are to expand and to replace or renew fixed assets. Another reason is to develop new products. Most manufacturing firms have a big investment in long-term assets. Boeing Co., for instance, puts millions 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 must analyze long-term projects and select those that offer the best returns while maximizing the firm’s value.

This process is called capital budgeting. Decisions involving new products or the acquisition of another business are especially important. Another challenge managers face is assessing the value of proposed information technology expenditures.

How do firms raise the funding they need? They borrow money (debt), sell ownership shares (equity), and retain earnings (profits). The financial manager must assess all these sources and choose the one most likely to help maximize the firm’s value.

Like expenses, borrowed funds can be divided into short- and long-term loans. A short-term loan comes due within one year; a long-term loan has a maturity greater than a year. Short-term financing is shown as a current liability on the balance sheet. It is used to finance current assets and support operations. Short-term loans can be unsecured or secured.

Unsecured loans are made on the basis of the firm’s creditworthiness and the lender’s previous experience with the firm. An unsecured borrower does not have to pledge specific assets as security. The three main types of unsecured short-term loans are trade credit, bank loans, and commercial paper.

Trade Credit: Accounts Payable When Goodyear sells tires to General Motors, GM does not have to pay cash on delivery. Instead Goodyear regularly bills GM for its tire purchases, and GM pays at a later date.

This is an example of a trade credit—the seller extends credit to the buyer between the time the buyer receives the goods or services and when it pays for them. Trade credit is a major source of short-term business financing.

The buyer enters the credit on its books as an account payable. In effect, the credit is a short-term loan from the seller to the buyer of the goods or services. Until GM pays Goodyear, Goodyear has an account receivable from GM—and GM has an account payable to Goodyear.

Bank Loans Unsecured bank loans are another source of short-term business financing. Companies often use these loans to finance seasonal (cyclical) businesses. For instance, a swimwear manufacturer has strong sales in the spring and summer and lower sales during the fall and winter. It needs short-term bank financing to increase inventories before its strongest selling season and to finance accounts receivable during the late winter and early spring, as shown in Exhibit 21-2, page 630. The company repays these bank loans when it sells the inventory and collects the receivables.

Unsecured bank loans include lines of credit and revolving credit agreements. A line of credit is an agreement between a bank and a business. It specifies the maximum amount of unsecured short-term borrowing the bank will allow the firm over a given period, typically one year. A line of credit is not a guaranteed loan; the bank agrees to lend funds only if it has money available. Usually, the firm must repay any borrowing within a year. It must also either pay a fee or keep a certain percentage of the loan amount (10 to 20 percent) in a checking account at the bank.

Another bank loan, the revolving credit agreement, is basically a guaranteed line of credit. Because the bank guarantees that a certain amount of funds will be available, it charges an extra fee in addition to interest. Revolving credit agreements are often arranged for a two- to five-year period.

Firms often obtain annual lines of credit based on their expected seasonal needs. Then they can quickly borrow without having to reapply to the bank each time funds are needed.

Loans for which the borrower is required to pledge specific assets as collateral, or security.

A form of short-term financing in which a firm sells its accounts receivable outright at a discount to a factor.

A financial institution (usually a commercial bank or commercial finance company) that buys accounts receivable at a discount.

The chance that a firm will be unable to make scheduled interest and principle payments on its debt.

A business loan with a maturity of more than one year; can be unsecured or secured.

Lone-term debt obligations (liabilities) issued by corporations and governments.

Payments to stockholders in the form of more stock; may replace or supplement cash dividends.

An equity security for which the dividend amount is set at the time the stock is issued.

Venture capital is another source of equity capital. It is most often used by small and growing firms that aren’t big enough to sell securities to the public.

The process of identifying and evaluating risks and selecting and managing techniques to adapt to risk exposures.

Finance involves managing the firm’s money. The financial manager must decide how much money is needed and when, how best to use the available funds, and how to get the required financing. The financial manager’s responsibilities include financial planning, investing (spending money), and financing (raising money). Maximizing the value of the firm is the main goal of the financial manager, whose decisions often have long-term effects.

Financial planning enables the firm to estimate the amount and timing of the financial resources it needs to meet its business goals. The planning process begins with forecasts based on the demand for the firm’s products. Short-term forecasts project expected revenues and expenses for one year. They are the basis for cash budgets, which show the flow of cash into and out of the firm and are used to plan day-to-day operations. Long-term forecasts project revenues and expenses for 2 to 10 years. These strategic plans allow top management to analyze the impact of different options on the firm’s profits.

A firm invests in 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, and equipment. Because of the large outlays required for capital expenditures, financial managers carefully analyze proposed projects to determine which offer the best returns.

Short-term financing comes due within one year. The main sources of unsecured short-term financing are trade credit, bank loans, and commercial paper. Secured loans require a pledge of certain assets, such as accounts receivable or inventory, as security for the loan. Factoring, or selling accounts receivable outright at a discount, is another form of short-term financing.

Financial managers must choose the best mix of debt and equity for their firm. The main advantage of debt financing is the tax-deductibility of interest. But debt involves financial risk because it requires payment of interest and principal on specified dates. Equity—common and preferred stock—is considered a permanent form of financing on which the firm may or may not pay dividends. Dividends are not tax-deductible.

The main types of long-term debt are term loans, bonds, and mortgage loans. Term loans can be secured or unsecured and generally have 5- to 12-year maturities. Bonds usually have maturities of 10 to 30 years. Mortgage loans are secured by real estate. Long-term debt usually costs more than short-term financing because of the greater uncertainty that the borrower will be able to make the scheduled loan payments.

The chief sources of equity financing are common stock, retained earnings, and preferred stock. The cost of selling stock includes issuing costs and potential dividend payments. Retained earnings are profits reinvested in the firm. For the issuing firm, preferred stock is more expensive than debt because its dividends are not tax-deductible and its claims are secondary to those of debtholders, but less expensive than common stock. Venture capital is often a source of equity financing for young companies.

Globalization brings additional complexity to financial management. Financial managers must be prepared to invest and raise funds overseas and make transactions in multiple currencies. Financial managers are spending more time on risk management, identifying and evaluating risks and selecting techniques to control and reduce risk. Companies face a wide range of risks, including credit, risk, market risk, and operational risk.