INTRODUCTION TO FINANCIAL MANAGEMENT

A Student Guide for ABM124 Students

I. INTRODUCTION TO FINANCE

Definition

Finance is the art and science of managing money.

At the personal level, finance is concerned with individuals’ decisions about how much of
their earnings they spend, how much they save, and how they invest their savings.

In a business context, finance involves the same types of decisions: how firms raise money
from investors, how firms invest money in an attempt to earn a profit, and how they decide
whether to reinvest profits in the business or distribute them back to investors.

Goal

The goal of finance is to maximize the wealth of the owners (shareholders) for whom it is
being operated, or equivalently, to maximize the stock price.

The goal of profit maximization is too simplistic in that it assumes away the problems of
uncertainty of returns and the timing of returns. Rather than use this goal, we have chosen
maximization of shareholders' wealth—that is, maximization of the market value of the firm's
common stock—because the effects of all financial decisions are included. The shareholders
react to poor investment or dividend decisions by causing the total value of the firm's stock to
fall and react to good decisions by pushing the price of the stock upward. In this way, all
financial decisions are evaluated, and all financial decisions affect shareholder wealth.

The goal of shareholder wealth maximization must be looked at as a long-run goal. As

such, the public image of the firm may be of concern inasmuch as it may affect sales and
legislation. Thus, while these actions may not directly result in increased profits, they may
affect consumers' and legislators' attitudes.

Although that goal sounds simple, implementing it is not always easy. To determine
whether a particular course of action will increase or decrease a firm’s share price, managers
have to:

(1) assess what return (that is, cash inflows net of cash outflows) the action will bring and
how risky that return might be; and indirectly

(2) satisfy the demands of other interest groups (e.g. customers, employees, and
suppliers).

Purpose

We study finance for…

1. Marketing – Budgets, marketing research, marketing financial products

2. Accounting – Dual accounting and finance function, preparation of financial statements

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 3. Management – Strategic thinking, job performance, profitability

4. Personal finance – Budgeting, retirement planning, college planning, day-to-day cash

flow issues

II. LEGAL FORMS OF ORGANIZATION*

Although numerous and diverse, the legal forms of business organization fall into three
categories: the sole proprietorship, the partnership, and the corporation. To understand the
basic differences among these forms, we need to define each one and understand its
advantages and disadvantages.
A. Sole Proprietorship – A sole proprietorship is a business owned by one person who
operates it for his or her own profit. The typical sole proprietorship is small, such as a sari-
sari store, convenience store, barbershop, parlor, and hardware shop.

Advantages of a Sole Proprietorship

(1) Owner receives all profits.
(2) Low organizational cost
(3) Income is included and taxed on proprietor’s personal tax return
(4) Independence
(5) Secrecy
(6) Ease of dissolution

Disadvantages of a Sole Proprietorship

(1) Owner has unlimited liability – total wealth can be taken to satisfy debts
(2) Limited fund-raising power tends to inhibit growth
(3) Proprietor must be jack-of-all-trades
(4) Difficult to give employees long-run career opportunities

(5) Loses continuity when proprietor (owner) dies

B. Partnership – A partnership formed through “a contract whereby two or more persons

bind themselves to contribute money, property, or industry into a common fund with the
intention of dividing profits among themselves.” (Art. 1767, Civil Code of the Philippines)

Characteristics of a Partnership
1. Mutual agency. Any partner may act as agent of the partnership in conducting its affairs.

2. Unlimited liability. The personal assets (assets not contributed to the partnership) of any
partner may be used to satisfy the partnership creditor’s claims upon liquidation, if
partnership assets are not enough to settle liabilities to outsiders.

3. Limited life. A partnership may be dissolved at any time by action of the partners or by
operation of law.

4. Mutual participation in profits. A partner has the right to share in partnership profits.

5. Legal entity. A partnership has a legal personality separate and distinct from that of
each of the partners.
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 6. Income tax. Partnerships, except general professional partnerships (i.e. those organized
for the exercise of profession like CPAs, lawyers, engineers, etc.) are subject to 30%
income tax.

Advantages of a Partnership
(1) It is easy and inexpensive to organize, as it is formed by a simple contract between two
or more persons.
(2) The unlimited liability of the partners makes it reliable from the point of view of
creditors.
(3) The combined personal credit of the partners offers better opportunity for obtaining
additional capital than does a sole proprietorship.
(4) The participation in the business by more than one person makes it possible for a closer
supervision of all the partnership activities.
(5) The direct gain to the partners is an incentive to give close attention to the business.
(6) The personal element in the characters of the partners is retained.

Disadvantages of a Partnership
(1) The personal liability of a partner for firm debts deters many from investing capital in a
partnership.
(2) A partner may be subject to personal liability for the wrongful acts or omission of his/her
associates.
(3) It is less stable because it can easily be dissolved.
(4) There is divided authority among the partners.
(5) There is constant likelihood of dissension and disagreement when each of the partners
has the same authority in the management of the firm.

C. Corporation – a corporation is an artificial being created by operation of law, having the

right of succession and the powers, attributes and properties expressly authorized by law or
incident to its existence. (Sec. 1, Corporation Code of the Philippines)

Characteristics of a Corporation
(1) Separate legal entity – artificial being . A corporation is an artificial being with a
personality and separate and distinct from that of its individual owners. Thus, it may,
under its corporate name, take, hold or convey property to the extent allowed by law,
enter into contracts, and sue or be sued.

(2) Created by operation of law. A corporation is generally created by operation of law. The
mere agreement of the parties cannot give rise to a corporation.

(3) Right of succession. A corporation has the right of succession. Irrespective of the death,
withdrawal, insolvency, or incapacity of the individual members or shareholders, and
regardless of the transfer of their interest or share capital, a corporation can continue its
existence up to the period stated in the articles of incorporation but not to exceed 50
(fifty) years.

(4) Powers, attributed, properties authorized by law . A corporation has only the powers,
attributes and properties expressly authorized by law or incident to its existence. Being a

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 mere creation of law, a corporation can only exercise powers provided by law and those
powers which are incidental to its existence.

(5) Ownership divided into shares. Proprietorship in a corporation is divided into units
known as share capital. The buyers of this share capital are called shareholders or
stockholders and are considered owners of the business.

(6) Board of directors. Management of the business is vested in a board of directors elected
by shareholders. The board of directors is the governing body or decision-making body
of the corporation. The Corporation Law provides that the number of directors be not
less than five but not more than fifteen.

Advantages of a Corporation
(1) The corporation enjoys a continuous existence because of its power of succession.
(2) The corporation has the ability to obtain a strong credit line because of continuity of
existence.
(3) Large scale business undertakings are made possible because many individuals can
invest their funds in the enterprise.
(4) The liability of its investors or shareholders is limited to the extent of their investment in
the corporation.
(5) The transfer of shares can take effect without the need of prior consent of other
shareholders.
(6) Its smooth operation is guaranteed because of its centralized management.

Disadvantages of a Corporation
(1) It is not easy to organize because of its complicated legal requirements and high costs
in its organization.
(2) The limited liability of its shareholders may weaken its credit capacity.
(3) It is subject to rigid governmental control.
(4) It is subject to more taxes.
(5) Its centralized management restricts a more active participation by shareholders in the
conduct of its corporate affairs.

*Note: This part of the manual entitled “legal forms of organization” will be thoroughly discussed in the
Fundamentals of Accounting, Business and Management. Hence, it is not entirely necessary for
the BF teacher to discuss further about these.

III. CASH FLOW CYCLE IN AN ORGANIZATION

The cash flow cycle is a pattern and timing of where cash comes from and where it goes in a
firm.

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 Cash is important because it is crucial to three activities that every business faces.
1. First, a firm needs to invest in real assets, or assets that produce goods or help provide
services, in order to function as a business; it also needs to invest in working capital.
These real assets may be tangible, such as plants and equipment, or they may be
intangible, such as investments in research and patent development, whereas working
capital investments represent money tied up in inventory and money owed by customers
who buy on credit.

2. Second, a firm must finance or pay for its real assets, meaning it must have cash on
hand or be able to obtain cash from some external source, such as a bank or investor.
The firm obtains cash from this source in exchange for taking on some obligation, such
as agreeing to pay annual interest on a loan and to pay back the loan in a certain
number of years.

3. Third, a firm needs to generate cash from its operations.

IV. DIFFERENT INDIVIDUALS INVOLVED IN THE FINANCE FUNCTION OF THE

ORGANIZATION

Role of the Different Personnel of the Organization involved in the Financial

Management

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 1. The vice president for finance, also called the chief financial officer (CFO), serves under
the firm’s chief executive officer (CEO) and is responsible for overseeing financial
planning, strategic planning, and controlling the firm’s cash flow. Typically, a treasurer
and controller serve under the CFO.

2. The treasurer generally handles the firm’s financial activities, including cash and credit
management, making capital expenditure decisions, raising funds, pension fund
management, financial planning, and managing any foreign currency received by the
firm.

3. The controller is responsible for managing the firm’s accounting duties, including
producing financial statements, cost accounting, paying taxes, and gathering and
monitoring the data necessary to oversee the firm’s financial well-being.

Additionally, these are other personnel involved in the finance function of the organization.

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Role of a Financial Manager
Accordingly, a financial manager (commonly known as the CFO or Chief Financial Officer)
has four main duties: assessing the current business, assessing future financing needs,
developing long-term financing strategies, and assessing future investments. To elaborate,
financial managers are concerned with the following tasks:
 Understanding the firm’s present business situation and measuring its current
performance.

 Assessing the firm’s future financial needs in the short and medium term (say, over the
next one to five years).

 Determining the best way to obtain cash to pay for real assets (known simply as
financing) and assessing other financing decisions, including how best to manage money
generated by the operations of the business. For example, financial managers must
decide whether earnings available after expenses and taxes should be paid directly to
the firm’s shareholders in the form of dividends or reinvested back into the firm in the
form of retained earnings.

 Investing money in the various operations of the business (known simply as capital
budgeting or investing) and seeking ways to maximize the value of the firm by growing
cash flows while mitigating risk.

V. FINANCIAL INSTITUTIONS, INSTRUMENTS AND MARKETS

A Financial Institution is an intermediary that channels the savings of individuals,

businesses, and governments into loans or investments.

1. Banks – Banks provide mechanism where savers can put their excess funds through
deposits. Banks give the depositors interest on the money deposited to them. To
cover/compensate the interest given to depositors, banks either lend the money to
borrowers (with a corresponding interest and after qualifying from a credit investigation)
or invest them on some financial instruments such as government securities and
corporate bonds.
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 2. Credit unions – Credit unions are cooperative associations whose members have a
common bond, such as being employees of the same firm or living in the same
geographic area. Members’ savings are loaned only to other members, generally for
auto purchases, home improvement loans, and home mortgages. Credit unions are
often the cheapest source of funds available to individual borrowers.

3. Pension funds – Pension funds are retirement plans funded and provided by
corporations or government agencies. Pension funds invest primarily in bonds, stocks,
mortgages, hedge funds, private equity, and real estate.

4. Life insurance companies – Life insurance companies take premiums, invest these funds
in stocks, bonds, real estate, and mortgages, and then make payments to beneficiaries.
Life insurance companies also offer a variety of tax-deferred savings plans designed to
provide retirement benefits.

5. Mutual funds – Mutual funds are corporations that accept money from savers and then
use these funds to buy financial instruments. These organizations pool funds, which
allow them to reduce risks by diversification and achieve economies of scale in analyzing
securities, managing portfolios, and buying/selling securities.

Financial Instruments
Financial instruments are financial securities which are simply pieces of paper with
contractual provisions that entitle their owners to specific rights and claims on specific cash
flows or values. Generally, these can be classified into two major categories: equity securities
and debt securities.
1. Equity Securities – these are securities that represent ownership in a company or rights
to acquire ownership interests at an agreed-upon or determinable price. A company may
issue two classes of equity instruments, namely, ordinary share capital (ordinary stocks)
and preference share capital (preferred stocks).

a. Ordinary Share Capital (Ordinary Stocks) – it entitles the holder to an equal or pro-
rata division of profits without any preference or advantage over any class of stocks
or equity securities.

b. Preference Share Capital (Preferred Stocks) – it entitles the holder to enjoy priority
as to distribution of dividends and distribution of assets upon corporate liquidation.

2. Debt Securities – these are instruments representing a creditor relationship with an

enterprise. These are the following characteristics of debt securities: (1) maturity value,
periodic interest payments at a fixed or variable interest rate, and (3) maturity date.
This type of securities may take in the form of bills, notes, bonds, commercial papers, or
promissory notes.

a. Treasury Bills - Treasury Bills are government securities issued by the Bureau of the
Treasury (BOTr) which mature in less than a year. There are three tenors of
Treasury Bills: (1) 91 day (2) 182-day (3) 364-day Bills. The number of days is based
on the universal practice around the world of ensuring that the bills mature on a
business day.
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 b. Treasury Bonds – Treasury Bonds are government securities issued by the Bureau of
the Treasury (BOTr) which mature beyond one year. At present there are five
maturities of bonds (1) 2- year (2) 5 – year (3) 7 – year 4) 10 – year and (5) 20-year.
These are sold at its face value on origination. 

c. Corporate Bonds – These are debt obligations issued by corporations to raise money
in order to expand their businesses. In the Philippines, the tenors are usually 5
years, 7 years or 10 years.

Financial Markets
A financial market is a place where individuals and organizations wanting to borrow funds
are brought together with those having a surplus of funds.
Types of Financial Markets
(1) Physical assets vs. Financial assets
Physical asset markets (also called “tangible” or “real” asset markets) are those for such
products as wheat, autos, real estate, computers, and machinery. Financial asset
markets, on the other hand, deal with stocks, bonds, notes, mortgages, derivatives, and
other financial instruments.
(2) Money vs. Capital
Money markets are the markets for short-term, highly liquid debt securities, while capital
markets are the markets for corporate stocks and debt maturing more than a year in the
future.

(3) Primary vs. Secondary

Primary markets are the markets in which corporations raise new capital. If Microsoft
were to sell a new issue of common stock to raise capital, this would be a primary
market transaction. The corporation selling the newly created stock receives the
proceeds from such a transaction. Secondary markets are markets in which existing,
already outstanding securities are traded among investors.

(4) Spot vs. Futures

Spot markets and futures markets are markets where assets are being bought or sold
for “on-the-spot” delivery (literally, within a few days) or for delivery at some future
date, such as 6 months or a year into the future.

(5) Public vs. Private

Private markets, where transactions are worked out directly between two parties, are
differentiated from public markets, where standardized contracts are traded on
organized exchanges. Bank loans and private placements of debt with insurance
companies are examples of private market transactions.

VI. FINANCIAL MANAGEMENT FRAMEWORK

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Flow and Circulation of Funds and Financial Instruments (Securities) in the Over-all
Economy (Condensed Version)

This depicts the general flow of funds through and between financial institutions and
financial markets as well as the mechanics of private placement transactions. Domestic or
foreign individuals, businesses, and governments may supply and demand funds.

Flow and Circulation of Funds and Financial Instruments (Securities) in the Over-all
Economy (Segmented Version)

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 In a well-functioning economy, capital flows efficiently from those with surplus capital to
those who need it. This transfer can take place in the three ways described in the above
illustration.
1. Direct transfers of money and securities, as shown in the top section, occur when a
business sells its stocks or bonds directly to savers, without going through any type of
financial institution. The business delivers its securities to savers, who, in turn, give the
firm the money it needs. This procedure is used mainly by small firms, and relatively
little capital is raised by direct transfers.

2. As shown in the middle section, transfers may also go through an investment bank such
as BPI, which underwrites the issue. An underwriter serves as a middleman and
facilitates the issuance of securities. The company sells its stocks or bonds to the
investment bank, which then sells these same securities to savers. The businesses’
securities and the savers’ money merely “pass through” the investment bank. However,
because the investment bank buys and holds the securities for a period of time, it is
taking a risk—it may not be able to resell the securities to savers for as much as it paid.
Because new securities are involved and the corporation receives the proceeds of the
sale, this transaction is called a primary market transaction.

3. Transfers can also be made through a financial intermediary such as a bank, an

insurance company, or a mutual fund. Here the intermediary obtains funds from savers
in exchange for its securities. The intermediary uses this money to buy and hold
businesses’ securities, while the savers hold the intermediary’s securities. For example, a
saver deposits dollars in a bank, receiving a certificate of deposit; then the bank lends
the money to a business in the form of a mortgage loan. Thus, intermediaries literally
create new forms of capital—in this case, certificates of deposit, which are safer and
more liquid than mortgages and thus are better for most savers to hold. The existence
of intermediaries greatly increases the efficiency of money and capital markets.

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