Outside Sources of Financing

Financial management consists of all those activities that are concerned with obtaining money and using it effectively. Effective financial management involves careful planning. It begins with a determination of the firm’s financial needs.

Money is needed to start a business. Then the income from sales could be used to finance the firm’s continuing operations and to provide a profit.

But sales revenue does not generally flow evenly. Income and expenses may vary from season to season or from year to year. Temporary financing may be needed when expenses are high or income is low. Then, the need to purchase a new facility or ex­pand an existing facility may require more money than is available within a firm. In these cases the firm must look for outside sourc­es of financing. Usually it is short- or long-term financing.

1. Short-term financing is money that will be used for one year or less and then repaid.

There are many short-term financing needs. Two deserve spe­cial attention. First, certain necessary business practices may af­fect a firm’s cash flow and create a need for short-term financ­ing.

Cash flowis the movement of money into and out of an orga­nization. The ideal is to have sufficient money coming into the firm, in any period, to cover the firm’s expenses during that period. But the ideal is not always achieved. For example, a firm that offers credit to its customers may find an imbalance in its cash flow. Such credit purchases are generally not paid until thirty or sixty days (or more) after the transaction. Short-term financing is then needed to pay the firm’s bills until customers have paid their bills. Unanticipated expenses may also cause a cash-flow problem.

A second major need for short-term financing that is related to a firm’s cash-flow problem is inventory.

Inventoryrequires considerable investment for most manufacturers, wholesalers, and retailers. Moreover, most goods are manufactured four to nine months before they are sold to the ulti­mate customer. As a result, manufacturers often need short-term financing. The borrowed money is used to buy materials and supplies, to pay wages and rent, and to cover inventory costs until the goods are sold. Then, the money is repaid out of sales revenue. Additionally,wholesalers and retailers may need short-term fi­nancing to build up their inventories before peak selling periods. Again, the money is repaid when the merchandise is sold.

2. Long-term financing is money that will be used for longer period than one year. Long-term financing is needed to start a new business. It is also needed for executing business expan­sions and mergers, for developing and marketing new products, and for replacing equipment that becomes obsolete or inefficient. The amounts of long-term financing needed by large firms can be very great (2400).

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