- •Chapter 6: Financing a Business
- •The Sources Of Business Funds
- •When Businesses Borrow
- •Buying And Selling Stocks And Bonds
- •Business Accounting: Balance Sheet And Income Statement
- •Summary
- •Looking Ahead
- •The History of Economic Thought Jean Baptiste Say (1767-1832) Say's Law of Markets
- •Reading for Enrichment Leverage And the Cost of Borrowing
When Businesses Borrow
Business loans are generally classified as either short-term or long-term loans. For short-term loans, the principal (the amount borrowed) must be repaid within one year. Long-term loans mature (come due) in more than a year. Creditors, people who make loans, expect to receive interest (payments for the use of their money) and the return of the principal at the end of a specific period of time. Interest is expressed as a percentage of the principal.
Short-term Financing. Short-term loans are used to finance the everyday costs of doing business, such as payrolls, raw materials, and merchandise. The most common types of short-term financing are trade credit, loans from financial institutions, and loans from investors.
Trade credit works like a department store charge account. Customers charge purchases to their accounts for payment at a later date. But here the customers are businesses whose suppliers allow them to charge purchases of materials and other items for later payment.
Loans from financial institutions, such as banks and finance companies, are another source of short-term credit.
Finally, some of the nation's largest businesses can obtain loans from investors to meet their short-term financial needs. If, for example,
General Motors needed $10 million to finance a payroll, it could raise the money by selling commercial paper — a kind of IOU issued by a corporation, promising to repay a sum of money at a specified rate of interest. Investors wishing to earn interest on their surplus funds can buy these lOUs from brokers specializing in such investments.
L
6-3 Cash Flow Statement
The Cash Flow Statement One
problem faced by many firms is that some times are better than
others. Sometimes sales boom, sometimes sales drop. But many
business expenses, like payrolls, rent, and utilities, remain
constant and must be paid. For that reason, those who manage
businesses keep a close watch on their cash flow. Cash
flow refers to the amount of money coming into and going out of a
firm over a specific period of time.
Business
managers often track their cash flow with a cash-flow statement.
When the statement shows a surplus, money can be set aside for
later use. When it shows a deficit, the shortfall has to be
covered by savings or with borrowed funds.
The cash-flow statement below
is typical, but cash-flow statements will differ depending on the
nature and needs of each business.
Cash-Flow Statement
For the period ending October 31, 199x
Cash Flow from operations
Cash received from customers
570,841
Cash paid to suppliers
(105,000)
Cash paid for services
(132,275)
Cash paid to employees
(252,000)
Cash paid for rent/insurance
(145,000)
Interest received
5,321
Income taxes paid
(32,200)
Cash provided by operations
(90,313)
Cash Flow from investing activities
Capital expenditures
0
Proceeds from sale of assets
15,000
Other
0
Cash used in investing activities
15,000
Cash flow from financing activities
Net short-term borrowing (payments)
100,000
Principal payments of long-term debt
(17,325)
Addition to long-term debt
0
Cash provided by financing activities
82,675
Net increase (decrease) in cash
7,362
Cash at beginning of period
10,721
Cash at end of period
18,083
Why would anyone lend money to a business for a year or more? Because revenues from these kinds of projects (like a new factory) continue to flow for a long period of time. This makes it possible for borrowers to repay their loans as promised.
Common sources of long-term financing are retained earnings, long-term loans, and the sale of stock.
Retained earnings are undistributed profits. Corporations can do one of two things with their profits: distribute them to their shareholders in the form of dividends, or retain them and plow them back into the business. Sometimes these retained earnings are used to finance major projects.
Long-term loans are repaid over more than one year. The most common form of long-term loan is the mortgage, a loan secured by real estate (land or buildings). If the borrower fails to make payments on the mortgage, the lender may take the property. Families who own a home or apartment probably have a mortgage on the property.
Many large corporations raise long-term capital through the sale of bonds. Corporate bonds are a kind of IOU sold to the general public, usually in amounts of $1,000. The corporation promises to repay the face value of the bond at a specific time. In addition, the bondholder receives interest according to a schedule — usually twice a year. Because the money paid for a bond is really a loan, bondholders are considered creditors of a corporation. This means the corporation legally must pay bondholders interest and principal when it is due.