What is the application of financial management in joint stock companies?

Answer 1

What Does Finance Management Involve?

All companies need to pay their bills and still have some money left over to improve the business. Furthermore, a key goal of any business is to increase the value to its owners (and other stakeholders) by making it grow. Maximizing the owner's wealth sounds simple enough: Just sell a good product for more than it costs to make. Before you can earn any revenue, however, you need money to get started. Once the business is off the ground, your need for money continues whether it's to buy new road repair equipment or to build a new warehouse.

Planning for firm's current and future money needs is the foundation of financial management or finance. This area of concern involves making decisions about alternative sources and uses of funds with the goal of maximizing a company's value. To achieve this goal, financial managers develop and implement a firm's financial plan; monitor a firm's cash flow and decide how to create or use excess funds; budget for current and future expenditures; recommend specific investments; develop a plan to finance the enterprise for future growth; and interact with banks and capital markets.

Developing and Implementing a Financial Plan:

One way companies make sure they have enough money is by developing a financial plan. Normally in the form of a budget, a financial plan is a document that shows the funds a firm will need for a period of time, as well as the sources and uses of those funds. When you prepare a financial plan for a company, you have two objectives: achieving a positive cash flow and efficiently invest access cash flow to make your company grow. Financial planning requires looking beyond the four walls of the company to answer questions such as: Is the company introducing a new product in the near future or expanding its market? Is the industry growing? Is the national economy declining? Is inflation heating up? Would an investment in new technology improve productivity?

o Monitoring cash flow An under laying concept of any financial plan is that all money should be used productively. This concept is important because without cash a company cannot purchase the assets and supplies it needs to operate or pay dividends to its shareholders. In accounting, we focused on the net income of firm. Cash flows are generally related to net income; that is, companies with relatively high accounting profits generally have relatively high cash flows, but the relationship is not precise. That's because net income can be generated from a variety of accounting transactions that do not directly impact a firm's cash on hand.

One way financial managers improve a company's cash flow is by monitoring its working capital accounts: Cash, inventory, accounts receivable and Accounts Payable. They use commonsense procedures such as shrinking accounts receivable collection periods, dispatching bills on a timely basis without paying bills earlier than necessary, controlling the level of inventory, and investing access cash.

o Managing Accounts Receivable and Accounts Payable Keeping an eye on accounts receivable-the money owned to the firm by its costumers-is one way to manage cash flow effectively. The volume of receivables depends on the financial managers' decisions regarding several issues: who qualifies for credit and who does not; how long costumers have to pay their bills; and how aggressive the firm is in controlling its debts. In addition to setting guidelines and policies to handle these issues, the financial manager analyzes the firm's outstanding receivables to identify patterns that might indicate problems and establish procedures for collecting overdue accounts.

The flip side of managing receivables is managing payables- the bills that the company owes to its creditors. Here the objective is generally to postpone paying bills until the last moment, since accounts payable represent interest- free loans from suppliers. However, the financial manager also needs to weigh the advantage of paying promptly if doing so entitles the firm to cash discounts. In addition, paying on time is a good way to maintain the company's credit standing, which it turns, influences a lender's decision to approve a loan. Of course, paying bills online with programs such as Intuit's Quicken and Microsoft Money is one way to manage cash aggressively and efficiently. As more and more companies deliver their bills as electronically to costumers via internet, and as such services become more reliable, online bill paying is expected to take off.

o Managing Inventory; Inventory is another area where financial managers can fine tune the firm's cash flow. Furthermore, the firm incurs expenses for storage and handling, insurance, and taxes. Additionally, there is always a risk that inventory will become obsolete before it can be converted into finished goods and sold. Thus, the firm's goal is to maintain enough inventories to fill orders in a timely fashion at the lowest cost. To achieve this goal financial managers work with operations managers and marketing managers to determine the economic order quantity (EOQ), or quantity of materials that, when ordered regularly, results in the, lowest ordering and storage cost.

o Managing Cash Reserves Sometimes companies find themselves with more cash on hand than they need. A seasonal business may experience a quiet period between the time when revenues are collected from the last busy season and the time when suppliers' bills are due. Department stores, for example, may have access cash during a few weeks in February and March. A firm may also accumulate cash to meet large financial commitments in the future or to finance future growth. Using a company's own money instead of borrowing from an outside source such as bank has one chief attraction: No interest payments are required. Finally, every firm keeps some surplus cash on hand as a cushion in case its needs are greater then expected.

Part of financial managers' job is to make sure that excess cash is invested so that it earns as much interest as possible. Aggressive financial managers use electronic cash management (the ability to access bank account information online) to move cash between accounts and pay bills on a daily basis; they also invest excess cash on hands in short-term investments called marketable securities. These interest-bearing or dividend-paying investments include money-market funds or publicly traded stocks such as IBM or Sears. They are said to be "marketable" because they can be easily converted back to cash. Because marketable securities are generally used as contingency funds, however, most financial managers invest these funds in securities or solid companies or the government-ones with the last amount of risk.

BUDGETING:

In addition to developing a financial plan and monitoring cash flow, financial managers are responsible for developing a budget, a financial blueprint for a given period (often one year). Master (or operating) budget help financial managers estimate the flow of money into and out of the business by structuring financial plans in a framework of a firm's total estimate revenues, expenses and cash flows. Accountants provide much of the data required for budgets and are important members of the budget development team because they have a complete understanding of the company's operating costs.

The master budget sets a standard for expenditure, provides guidelines for controlling costs, and offers an integrated and detailed plan for the future. For example, by reviewing the budget of any airline you can determine whatever the company plans on increasing its fleet of aircraft, adding more routes, hiring more employees, increasing employees' pay, or continuing or abandoning any discounts for travels. No wonder companies like to keep their budgets confidential. Once a budget has been developed, the finance manager compares actual results with projections to discover variance and then recommends corrective action-a process known as financial control.

· Capital BudgetingIn contrast to operating budgets, capital budgets forecast and plan for a firm's capital investments, such as major expenditure in buildings or equipments. Capital investments generally cover a period of several years and help the company grow. Before investments can be made, however, a firm must decide on which of many possible capital investments to make, how to finance those that are undertaken, and even whether to make any capital investment at all. This process is called capital budgeting.

The process generally begins by having all divisions within a company submit their capital requests-essentially, "wish lists" of investment that would make the company more profitable and thus more valuable to its owners over time. Next the financial manager decides which investments need evaluating and which don't. For example, the routine replacement of old equipment probably wouldn't need evaluating; however the construction of the new manufacturing facility would. Finally, a financial evaluation is performed to determine whether the amount of money required for particular investment will be greater than, equal to or less than the amount of revenue it will generate. On the basis of this analysis, the financial manager can determine which projects to recommend to senior management for purchase approval.

· Forecasting Capital Requirements Keep in mind that as with any major investment decision, an erroneous forecast of capital requirements can have serious consequences. If the firm invests too much in assets, it will incur unnecessarily heavy expenses. If it does not replace or upgrade existing assets on regular basis, the assets will likely become obsolete. For example, old manufacturing equipment may be incapable of handling increasing capacities. This could even result in a loss of market share to competitors. For these important reasons, firms try to match capital investments with the company's goals. In other words, if the firm is growing, then projects that would produce the greatest growth rates would receive highest priority. However, if the company is trying to reduce costs, those projects that enhance the company's efficiency and productivity would be ranked towards the top. Because asset expansion frequently involves large sums of money and affects the company's productivity for an extended period of time, finance manager must carefully evaluate the best way to finance or pay for these investments, another major responsibility of finance managers.

Financing theEnterprise:

Most companies can't operate and grow without a periodic infusion of money. Firms need money to cover the day-to-day expenses of running business, such as paying employees and purchasing inventory. They also need money to acquire new assets such as land, production facilities, and equipment.

Where can existing firms obtain the money they need to obtain and grow? 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 leaders. In addition, public companies can raise funds by selling share of stock, and large corporations can sell bonds.

Financing an enterprise is a complex undertaking. The process begins by assessing the firm's financing needs and determining whether funds are needed for the short or long term. Next the firm must assess the cost of obtaining those funds. Finally, it must wait the advantages and disadvantages of financing through debt or equity, taking into consideration the firm's special needs and circumstances in addition to the advantages and disadvantages of public verses private ownership. The financing process is further complicated by the fact that many sources of long-term financing exist-each with their own special attributes, risks, and costs.

Length of TermFinancing can be either short-term or long-term. Short-term financing is any financing that will be repaid with one year, whereas long-term financing is any financing that will be repaid in a period longer then one year. The primary purpose of short-term financing is to ensure that the company maintains its liquidity, or its ability to meet financial obligations (such as inventory payments) as they become due. By contrast, long-term financing is used to acquire long-term assets such as building and equipment or to fund expansion via any number of growth options. Long-term financing can come from both internal and external sources.

Cost of Capital In general, a company wants to obtain money at the lowest cost and least amount of risk. However, lenders and investors want to receive a highest possible return on their investment, also at the lowest risk. A company's cost of capital, the average rate of interest it must pay on its debt and equity financing, depends on three main factors: the risk associated with the company, the prevailing level of interest rates, and management's selection of funding vehicles.

Risk Lenders and investors who provide money to business expect their return to be in proportion to the two types of risk they face: the quality and length of time of the venture. Obviously, the more financially solid a company is the less risk investors' face. However, time also plays a vital role. Because a dollar will be worthless tomorrow than it is today, lenders need to be compensated for waiting to be repaid. As a result, long-term financing generally costs a company more than short-term financing.

Interest RatesRegardless of how financially solid a company is the cost of money will vary over time because interest rates fluctuate. The prime interest rate (prime) is a lowest interest rate offered on short-term bank loans to preferred borrowers. The prime changes irregularly and, at times, quite frequently-sometimes because of supply and demand and other times because the prime rate is closely tied to the discount rate, the interest rate Federal Reserve Banks charge on loans to commercial banks and other depository institutions.

OpportunityCost Using a company's own cash to finance its growth has one chief attraction: No interest payments are required. Nevertheless, such internal financing is not free; this money has opportunity cost. That is, a company might be better of investing its excess cash in external opportunities, such as another company's project or stock of growing companies, and borrowing money to finance its own growth. Doing so makes sense as long as the company can earn a greater rate of return, the percentage increase in the value of an investment, on external investments than the rate of interest paid on borrowed money. This concept is called leverage because the loan acts like lever: It magnifies the power of the borrower to generate profit. However, leverage works both ways: Borrowing may magnify your losses as well as your gains. Because most companies require some degree of external financing from time to time, the issue is not so much whether to use outside money; rather, it's a question of how much should be raised, by what means, and when. The answers to such questions determine the firm's capital structure, the mix of debt and equity.

Debt Versus Equity Financing 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. Equity financing is achieved by selling shares of a company's stock. When choosing between debt and equity financing, companies consider a variety of issues, such as the cost of the financing, the claim on income, the claim on assets, and the desire for ownership control.

Common Types of Debit Financing Two common types of short-time debt financing are trade credit (or open-account purchase) from suppliers-allowing purchasers to obtain products before paying for them; and commercial paper-short-term promissory notes of major corporations usually sold in denominations of $100,000 or more, with maturities of up to 270 days (the maximum allowed the SEC without registration.

Loans, another common source of debt financing, can be long-term or short-term and secured or unsecured. Secured loans are those backed by something of value, known as collateral, which may be seized by the lender in the event that the borrower fails to repay the loan. The most common type of secured loan is a mortgage, in which a piece of property such as building is used to collateral. Other types of loan collateral are account receivable, inventories, marketable securities, and other assets. Unsecured loans are ones that require no collateral. Instead, the lender relies on the general credit record and the earning power of the borrower. To increase returns on such loans and to obtain some protection in case of default, most lenders insist that the borrower maintains some minimum amount of money on deposit at the bank-a compensating balance-while the loan is outstanding.

One example of an unsecured loan is a working capital line of credit, which is an agreed-on maximum amount of money a bank is willing to lend a business during a specific period of time, usually one year. Once a line of credit has been established, the business may obtain unsecured loans for any amount up to that limit, provided the bank has funds. The line of credit can be canceled at any time, so companies that want to be sure of obtaining credit when needed.

Financial Management for Small Business:

New business success and failure are often closely related to adequate or inadequate funding. For example, one study of nearly 3,000 new companies revealed a survival rate of 84 percent for new business with initial investments of at least $50,000. Unfortunately, those with less funding have a much lower survival rate. Why are so many start-ups underfunded? For one thing, entrepreneurs often underestimate the value of establishing bank credit as a source of funds and use trade credit ineffectively. In addition, they often fall to consider venture capital as a source of funding, and they are notorious for not planning cash flow needs properly.

Establishing Bank and Trade Credit:

Some banks have liberal credit policies and offer financial analysis, cash-flow planning, and suggestions based on experiences with other local firms. Some provide loans to small businesses in bad times and work to keep them going. Some do not. Obtaining credit begins with finding a bank that can-and will-support a small firms financial needs. Once a line of credit is obtained, the small business can seek more liberal credit policies from other businesses. Sometimes, suppliers give costumers longer credit period-45 or 60 days rather than 30 days. Liberal trade credit terms with their suppliers let firms increase short-term funds and avoid additional borrowing from banks.

Long-term LoansObtaining long-term loans is more difficult for new business than for established companies. With unproven repayment ability, start-up firm can expect to pay higher interest rates than older firms. If a new enterprise displays evidence of sound financial planning, however, the small business administrations may support a guaranteed loan.

The Business Plan as a Tool for Credit Start-up firms without proven financial success usually must present a business plan to demonstrate that the firm is a good credit risk. The business plan is a document that tells potential leaders why the money is needed, the amount, how the money will be used to improve the company, and when it will be paid back.

Photographer David Cupp needed $50,000 funding for a new firm, Photos online, Inc., in Columbus, Ohio, which displays and sells photos over the Internet. His business plan has to be rewritten many times until it became understandable, in financial terms, to potential lenders. The plan eventually reached 35 pages and contained information on the competition as well as cash flow projections. After four failed attempts, the fifth bank approved a $26,000 term loan and granted a $24,000 line of credit, to be used for computers, software, and living expenses to get the business started.

Venture Capital:

Many newer businesses-especially those undergoing rapid growth-can not get the funds they need through borrowing alone. They may, therefore, turn to venture capital: outside equity funding provided in return for part ownership of the borrowing firm. The venture capital firms actively seek chances to invest in new firms with rapid growth potential. Because failure rates are high, they typically demand high returns, which are now often 20 to 30 percent.

Planning for Cash-Flow Requirements:

Although all businesses should plan for their cash flows, this planning is especially important for small businesses. Success or failure may hinge on anticipating those times when either cash will be short or excess can be expected.

By; Uzair Kayani