BUSINESS FINANCE

the raising and managing of funds by business organizations. Such activities are crucial to the success of any firm and are usually the concern of senior management, although some routine aspects of financial operations may be carried out by lower-level staff. Because nonfinancial decisions may affect the firm's ability to raise capital in the future, financial officers also play an important role in operational management and the establishment of strategic goals. Financial management employs a variety of tools to gauge the performance and requirements of a firm. Ratio analysis is an important way of judging a firm's current health. For example, the ratio of current assets to current liabilities (current or liquidity ratio) is an index of the firm's ability to meet short-term obligations. Leverage ratios weigh the corporation's debt against its assets and the value of the stockholder's shares (equity). Activity ratios, measuring turnover of such assets as inventory and accounts receivable, indicate how intensively a firm is employing its assets. Profit ratios (e.g., as a percentage of sales or assets) indicate whether a firm is earning a good return on its invested capital. Financial forecasting is important in planning for the firm's future growth. Generally, management develops a long-term plan, deciding what types and quantities of products it will manufacture or what markets it will emphasize. Shorter-term budgets are then devised to fit this scheme. For example, if a firm is contemplating expanding or entering new markets, it must estimate its future costs and sales. Financial officers must analyze whether increased sales or the firm's own cash reserves will pay for the expansion; if new financing is needed, financial officers must decide on the best kind to seek. A firm's long-term plan may be sound, but it may be impossible to realize without sufficient cash flow. Thus, a cash budget, projecting the surplus or deficit of funds from day to day and month to month, is an essential financial tool. If a firm has excess cash, it may invest it in short-term securities, building a reserve against future obligations. Negative cash flow, however, may force a firm to borrow from banks to cover immediate expenses. A firm must also manage its accounts receivable (credit granted to customers) and inventories. Firms offer customers credit as a way of expanding sales; the risk of not being paid must be taken if new customers are to be won. Firms must also maintain inventories to assure steady supplies for customers and to take advantage of economies of scale, but inventories are expensive to hold, since the costs of manufacture and storage must be paid without recording a sale. Financial officers play an important role in judging the risks of extending credit to customers and in determining the optimum level of inventories. Such short-term considerations often create the need for short-term financing. The most common types are bank loans, trade credits extended by suppliers, and commercial paper (promissory notes sold by creditworthy corporations to other firms with a cash surplus). In general, short-term financing must be repaid in less than one year, intermediate-term obligations in one to 15 years, and long-term obligations in more than 15 years. Common intermediate-term financial arrangements include term loans from banks and installment sales contracts or leases for the acquisition of machinery. Leasing is especially advantageous for firms requiring expensive equipment that depreciates in value. Long-term capital may be raised in the form of either debt (bonds) or equity (stock). Bonds, which are promissory notes requiring the borrowing firm to pay holders specified interest payments at fixed intervals, create no claim on a firm's profits. Stockholders, on the other hand, have a claim on the corporation's profits. Thus, in choosing long-term financing strategies, corporate finance officers weigh the relative advantages of debt or equity financing. Regular interest payments to bondholders increase a firm's fixed costs while offering the firm leveragethe potential to increase profits without increasing equity, the total claims of shareholders. Issuing new stock, while creating no new fixed costs, dilutes the firm's profits per share of stock. Other factors affecting a choice between issuing bonds or stock include current conditions in the respective financial markets and the corporation's existing ratio of debt to equity. The amount of profits distributed to shareholders as dividends is an important corporate concern. A young, rapidly growing firm may choose to retain its earnings to reinvest; more mature corporations are likely to pay a larger dividend, either because their opportunities for growth are limited or because their capital needs are more easily met. There are other strategies for deploying corporate assets to increase growth. Mergerscorporate combinations in which one firm disappearswork best when the two businesses complement each other, thus making the whole greater than the sum of its parts. A large firm may also buy a smaller one, operating it as a subsidiary; the subsidiary retains legal and management autonomy. Conglomerates, which are firms combining many separate, unrelated businesses, attempt to take advantage of economies of scale in such senior management activities as financial and legal operations and marketing. When a firm faces bankruptcy, management may seek to liquidate or to reorganize it. In a liquidation the firm simply quits, selling whatever assets it has to pay its debts. In a reorganization the firm attempts to postpone or reduce debt payments, changing or scaling down its business strategy and perhaps obtaining concessions from employees or suppliers. Such a reorganization is generally a complicated procedure supervised by courts and requiring cooperation among management, shareholders, and creditors. the raising and managing of funds by business organizations. Planning, analysis, and control operations are responsibilities of the financial manager, who is usually close to the top of the organizational structure of a firm. Typically the manager is a member of the first level of the company staff in a large organization. In very large firms major financial decisions are often made by a finance committee. In small firms, the owner-manager usually conducts the financial operations. Much of the day-to-day work of business finance is conducted by lower level staff; their work includes handling cash receipts and disbursements, borrowing from commercial banks on a regular and continuing basis, and formulating cash budgets. Financial decisions affect both the profitability and the riskiness of a firm's operations. An increase in the cash position, for instance, reduces risk; but, because cash is not an earning asset, converting other types of assets to cash reduces the firm's profitability. Similarly, the use of additional debt raises the profitability of the firm, but more debt means more risk. Striking a balancebetween risk and profitabilitythat will maintain the long-term value of the firm's securities is the task of finance. Additional reading Comprehensive introductions to the theory of business finance include J. Fred Weston and Eugene F. Brigham, Essentials of Managerial Finance, 7th ed. (1985), and Managerial Finance, 7th ed. (1981); James C. Van Horne, Financial Management and Policy, 6th ed. (1983); Robert Willard Johnson, Financial Management, 5th ed. (1982); J.R. Franks and J.E. Broyles, Modern Managerial Finance (1979); and J.M. Samuels and F.M. Wilkes, Management of Company Finance, 3rd ed. (1980). A practical guide to balance sheet analysis and finance for the layman is R. Vause and N. Woodward, Finance for Managers, 2nd ed. (1981). S. Nicholas Woodward The Editors of the Encyclopdia Britannica