16.2 How Organizations Use Funds

Financial Resource Management

Every organization has to decide how to spend its money, both on daily operations and on bigger investments that shape the company's future. Understanding how businesses use funds is central to financial management, because even a profitable company can fail if it runs out of cash or invests in the wrong projects.

Short-Term vs. Long-Term Expenses

Businesses spend money on two fundamentally different timescales, and keeping them straight matters for planning and financial reporting.

Short-term operating expenses are the day-to-day costs of running the business:

• Salaries and wages
• Rent and utilities
• Office supplies
• Advertising and marketing

These show up on the income statement and directly affect short-term profitability and liquidity. If operating expenses spike unexpectedly, the company may struggle to pay its bills even if long-term prospects look great.

Long-term capital expenditures are larger investments in assets that deliver value over multiple years:

• Property, plant, and equipment
• Research and development
• Acquisitions and mergers

These are recorded on the balance sheet as assets (not immediately expensed on the income statement). They typically require large upfront costs and longer payback periods, but they drive long-term growth and competitiveness. A company that never makes capital expenditures will eventually fall behind.

Cash, Receivables, and Inventory Management

These three areas make up the core of working capital management, which is all about making sure the business has enough resources flowing through it to operate smoothly.

Cash Management

The goal is to keep enough cash on hand to meet obligations without letting too much sit idle. Common techniques include:

• Cash forecasting to predict when money comes in and goes out
• Accelerating receipts by offering customers small discounts for paying early (e.g., "2/10 net 30" means a 2% discount if paid within 10 days)
• Delaying disbursements by negotiating longer payment terms with suppliers
• Investing excess cash in short-term, low-risk securities like Treasury bills so idle money earns a return

Accounts Receivable Management

When a business sells on credit, it creates an account receivable. The challenge is minimizing the gap between making a sale and actually collecting cash. Strategies include:

• Setting clear credit policies and payment terms upfront
• Running credit checks on new customers before extending credit
• Invoicing promptly and accurately
• Following up on overdue accounts with a consistent collections process
• Factoring, which means selling receivables to a third party at a discount in exchange for immediate cash

Inventory Management

Holding too much inventory ties up cash and increases storage costs. Holding too little risks stockouts and lost sales. Businesses balance these tradeoffs using approaches like:

• Just-in-time (JIT) inventory: ordering materials to arrive right when they're needed, minimizing holding costs
• Economic order quantity (EOQ): a formula that calculates the optimal order size to minimize total ordering and holding costs
• ABC analysis: categorizing inventory items by value and importance so the most critical items get the closest attention
• Tracking systems like barcodes and RFID to monitor stock levels in real time

Capital Budgeting Techniques

When a company considers a major investment, like building a new factory or launching a product line, it uses capital budgeting to evaluate whether the project is worth the money. Here are the four main techniques:

Net Present Value (NPV)

NPV answers the question: After accounting for the time value of money, does this project create more value than it costs?

$NPV = \sum_{t=1}^{n} \frac{C_t}{(1+r)^t} - C_0$

• $C_t$ = net cash inflow during period $t$
• $C_0$ = initial investment
• $r$ = discount rate (the company's required rate of return)
• $n$ = number of time periods

Decision rule: Accept projects with a positive NPV. A positive NPV means the project returns more than the cost of the investment in today's dollars.

Internal Rate of Return (IRR)

IRR finds the discount rate at which a project's NPV equals zero. In other words, it tells you the project's effective annual return.

$0 = \sum_{t=1}^{n} \frac{C_t}{(1+IRR)^t} - C_0$

Decision rule: Accept the project if its IRR exceeds the company's required rate of return. For example, if a company requires a 10% return and the project's IRR is 14%, it's a good investment by this measure.

Payback Period

This is the simplest method. It measures how long it takes to recover the initial investment.

$Payback\ Period = \frac{Initial\ Investment}{Annual\ Cash\ Inflow}$

Decision rule: Accept projects that pay back within a set threshold. A company might require payback within 3 years, for instance. The limitation here is that payback period ignores the time value of money and any cash flows that occur after the payback date.

Profitability Index (PI)

PI measures the bang-for-your-buck of a project by comparing the present value of future cash flows to the initial cost.

$PI = \frac{Present\ Value\ of\ Future\ Cash\ Flows}{Initial\ Investment}$

Decision rule: Accept projects with a PI greater than 1. A PI of 1.25 means every dollar invested is expected to generate $1.25 in present-value terms. PI is especially useful when a company has limited funds and needs to rank competing projects.