Business Financing and Capital Structure Decisions

Financial Planning and Business Objectives

Financial planning involves forecasting short-term and long-term financial needs and future sales. The process begins by examining a company's objectives on a short-term basis (typically one year) and a long-term basis (at least five years). The short-term objective of the financial planning process is to achieve targeted profit by maintaining low expenses and higher revenues. For long-term planning, companies must understand their anticipated growth and expansion in both revenues and expenses. Asset investments will be required to meet both short- and long-term goals.

It is critical that companies determine the appropriate amount of dividends to distribute to shareholders versus the amount of profit to retain in the business for future expansion. If adequate financing is not retained internally, the company must seek external financing opportunities. Loans, stocks, and bonds are often used as other forms of financing. The decision regarding debt and equity financing depends on the costs and risks involved. Businesses typically choose the source that offers the lowest cost and least amount of risk.

Net Working Capital and Management Approaches

Net working capital is the difference between current assets and current liabilities. If a company has no current liabilities, then its total current assets equal its working capital, also known as gross working capital. The working capital requirement varies for each business. Businesses with high inventory requirements and significant credit sales maintain higher working capital. For example, the manufacturing sector typically requires more working capital than the service industry.

Companies use several different approaches when managing working capital. The aggressive working capital approach finances working capital needs through short-term sources of finance. Minimal investment is favored in this approach, and companies attempt to speed up their business cycles to increase sales and revenues. The conservative working capital approach finances assets through long-term sources of finance, which helps avoid risks. The moderate working capital approach uses short-term loans for temporary working capital and long-term loans for permanent working capital.

Companies using the conservative approach may experience periods of excess cash that is not needed during times of low activity. These excess funds can be invested in marketable securities such as U.S. Treasury Bills, government bonds, corporate bonds, common stock, and preferred stock. Treasury Bills and government bonds are risk-free but provide a low rate of return. Corporate bonds issued by public companies carry higher risk than government securities. Common stock and preferred stock pay dividends and offer higher rates of return to investors.

Debt and Equity Financing Options

Businesses may use both debt and equity sources of financing to raise capital. When debt financing is used, the business pays interest, which is tax-deductible. With equity financing, businesses pay dividends, which are not tax-deductible but rather represent a distribution of profit. Debt creates an obligation, while equity represents an investment.

The cost of debt financing is usually lower than equity financing. However, obtaining loans can be risky, and companies cannot finance all expenses through debt options alone. It is feasible for companies to use both debt and equity financing to maintain balance between cost and risk. This blended approach allows businesses to optimize their capital structure according to their specific financial circumstances and strategic objectives.

Risk and Return in Securities

Common stocks and corporate bonds have different levels of risk. Corporate bonds generally offer the lowest level of risk, while common stocks have a higher level of risk. However, corporate bonds offer lower returns, whereas common stocks have potentially the highest returns. The risk involved with corporate bonds depends on the financial stability and performance of the company issuing them.

Common stock also enables investors to become shareholders in the company. Investors can own multiple shares, which generate returns through dividends distributed by the company. However, there is a risk that share prices may drop from the original purchase price, resulting in profit loss. Understanding these risk-return tradeoffs is essential for making informed investment decisions.