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A. Financing the Enterprise
From Wall Street to Main Street – both overseas and at home – money is the one tool used to measure personal and business income and wealth. While it is certainly true that money makes the world go round, financial management is the discipline that makes the world turn more smoothly. Indeed, without effective management of assets, liabilities, and owners’ equity, all business organizations can fail – regardless of the quality and innovations of their products. Financial management, or finance, involves making decisions about alternative sources and uses of funds with the goal of maximizing the company’s value. In other words, financial management means the effective acquisition and use of money.
All companies need to pay their bills and still have some money left over to improve the business. A key goal of any business is to increase the value to its owners and other stakeholders by making it grow. Before you can earn any revenue, however, you need money to get started. The money needed to start and continue operating a business is known as capital.
A company needs capital to purchase essential assets, support research and development, and buy materials for production. Capital is also necessary for salaries and wages, pensions, fees, credit extension for customers, advertising, insurance, and many other day-to-day operations. In addition, financing is essential for growth and expansion of a company. Because of competition in the market, capital needs to be invested in developing new product lines and production techniques and in acquiring assets for future expansion.
Generally speaking, a company wants to obtain money at the lowest cost and the least amount of risk. Therefore, financial managers should take into account the cost of capital – the price a company must pay to raise money. The cost of capital depends on the risk associated with the company, the prevailing level of interest rates, and management’s selection of funding tools.
Where can a firm obtain the money it needs? The most obvious source would be revenues – cash received from sales, rentals of property, interest on short-term investments, and so on. Another likely source would be suppliers who may be willing to do business on credit, thus enabling the company to postpone payment. Most firms also obtain money in the form of loans from banks, finance companies, or other commercial lenders. In addition, public companies can raise funds by selling shares of stock, and large corporations can sell bonds.
It follows that business firms can raise money from internal (inside) and external (outside) sources. Thus, a company uses two basic types of financing: equity financing and debt financing. Equity financing refers to funds that are invested by owners of the corporation. Debt financing represents funds that are borrowed from sources outside the corporation.
Equity is the money a company gets from selling the shares it owns. Equity financing can be exemplified by the sale of corporate stock. This type of transaction describes an exchange of money for a share of business ownership – evidenced by a stock certificate. This form of financing allows a company to obtain funds without incurring debt; in other words, without having to repay a specific amount of money at any particular time. Some companies use their excess cash to finance their growth. Using a company’s own money has one chief attraction: no interest payments are required. For this reason, many companies accumulate excess earnings over a period of time instead of paying dividends to shareholders. Unless some dividends are paid, investors may lose interest in the company. Some companies also raise money internally by selling assets that are no longer needed.
Debt financing refers to what we normally think of as a loan. A creditor agrees to lend money to a debtor in exchange for repayment, with accumulated interest, at some future date. One of the biggest benefits of debt financing is that the lender does not have an ownership interest in your business and your obligations are limited to repaying the loan. On the other hand, companies face some disadvantages with debt financing – especially when interest rates are high and the amount required is large. For example, a company can sell stock and survive rough times by omitting dividend payments, but if it can’t meet its loan and bond commitments, it could be forced into bankruptcy.
Debt financing can be either short or long-term. Short-term debt is any debt that will be repaid within one year, whereas long-term debt is any debt that will be repaid in a period longer than one year. The three major types of short-term debt are (1) trade credit from suppliers allowing purchasers to obtain products before paying for them, (2) short-term commercial loans, and (3) commercial paper – short-term promissory notes of major corporations sold in minimum investments of $25,000 with a maturity date of 30 to 90 days. The three major types of long-term debt are loans, leases and bonds – certificates that obligate the company to repay a certain sum, plus interest, to the bond-holder on specific dates. Thus, the bond has a maturity date, a deadline when the company must repay all of the money it has borrowed.