How to uses financial tools

Section 6.0
Working Capital (Cash Management) 6-1

   Working Capital, Budgeting, and Cash Management all go hand in hand. We will focus on cash management first because all of the related topics have direct impact an cash management issues.

   Poor cash management is the reason why some firms have trouble when they try to borrow. Management often fails to forecast and plan for cash needs. The resulting business ailment is a cash crisis.

   Sound cash management must be practiced if revenues, expenses, and balance sheet accounts are to be used profitably. Such management includes: knowing the firm's cash flow, forecasting cash needs, planning to borrow at the appropriate time, and substantiating the firm's payback ability.

   In spite of respectable sales volumes, many managers of businesses run into financial trouble. Some get in so deep they are barely able to keep their heads above water. Others find themselves only weeks or months away from tacking "out of business" signs on their doors.

   Of ten manager s experiencing cash f1ow problems have three things in common. First, they know their line of business. Their technical ability is first rate. Second, they are poor cash managers or don't understand their current market. In many instances, they fail to plan ahead because of their enthusiasm for the operating side of their business. Third, often managers feel that additional money will solve their problems. Many managers think that a loan will pull them out of the red when good planning is the only thing that will help in the long term.

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Section 7.0
Cost of Capital, Internal and External 7-1

   There are many types and sources of capital. These are described briefly followed by discussions on risk, cost of capital, and internal and external cost of capital.

   Types and Sources of Capital. The capital to finance a business has two major forms: debt and equity. Creditor money (debt) comes from trade credit, loans made by financial institutions, leasing companies, and customers who have made prepayments on larger orders. Equity is money received by the company in exchange for some portion of ownership. Sources include the entrepreneur's own money; money from family and friends; monies generated by the business; and professional and non-professional investors.

   Debt capital, depending upon its sources (e.g., trade, bank, leasing company, mortgage company) comes into the business for short or intermediate periods. owner or equity capital remains in the company for the life of the business (unless replaced by other equity) and is repaid only when and if there is a surplus at liquidation of the business--after all creditors are repaid.

   Acquiring such funds depends entirely on the business's ability to repay with interest (debt) or appreciation (equity). Financial performance (reflected in the Financial Statements discussed in Section 2) and realistic, thorough management planning and control (shown by Pro Formas and Cash Flow Budgets, Section 3), are the determining factors in ,whether or not a business can attract the debt and equity funding it needs to operate and expand. Business capital can be further classified as equity capital, working capital, and growth capital.

   Equity capital is the cornerstone of the financial structure of any company. Equity is technically the part of the Balance Sheet reflecting the ownership of the company. It represents the total value of the business, all other financing being debt that must be repaid. Usually, you cannot use equity capital--at least not during the early stages of business growth.

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Section 8.0
Capital Decision Techniques 8-1

   Capital Decision Techniques have three basic focuses: Cash Flows, Cost of Capital, and Accept/Reject Criterion. All acquisitions should first pass the capital decision process before they are added to the capital budget. (Note Section 3.5 for additional information on the Capital Budget.)

   " Capital Budgeting involves the decision-making process of investing in any large asset acquisition, be it a new business, a building, computer equipment, etc. Capital budgeting decisions involve investments requiring rather large cash outlays at the beginning of the life of a project and committing the firm to a particular course of action over a relatively long time period. As such, they are both costly and difficult to reverse, because of: (1) their large cost; and (2) the fact that they involve fixed assets which cannot be liquidated easily.

   CASH FLOWS. In order to evaluate investment proposals we must first set up guidelines by which to measure the value of each proposal. In so doing we will focus our attention on CASH FLOWS RATHER THAN ACCOUNTING PROFITS. THIS CHOICE RESTS ON THE FACT THAT CASH FLOWS AND NOT ACCOUNTING PROFITS ARE ACTUALLY RECEIVED AND REINVESTED BY THE FIRM. Thus , by examining cash flows we are able to correctly analyze the timing of the benefits.

   A project's cash flow falls into three categories: (1) NET INITIAL OUTLAY, (2) After tax CASH FLOWS OVER THE PROJECT'S LIFE, and (3) TERMINAL CASH FLOW.

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Section 9.0
Lease Versus Buy Decision 9-1

   Almost all businesses sooner or later have difficulty in raising capital--that's no secret. This difficulty (among other reasons) has caused many to look at leasing as an alternative financing arrangement for acquiring assets. In the case of Non-Financial Professionals, the acquisition shown in Section 8 can be obtained and at the same time have no effect on current debt ratios. In fact, if management wants a sale and leaseback agreement might be arranged that would even lower the firm's debt ratio percentages. (Note Section 9.1.2.3.)

   This section describes various aspects of the lease versus buy decision. It lists advantages and disadvantages of leasing and provides a format for comparing costs.

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