INTRODUCTION TO BUSINESS FINANCE

LESSON 1 – Overview of Financial Management

Finance – the science and art of managing money. Economically, the fundamental concern of
finance, is to ensure that the limited financial resources are correctly managed, allocated, and
utilized in order to achieve the financial goal of a business.

Sources of finance can be internal or external. An internal source of finance does not increase the
debts of the business-like profit, savings, and sale of unwanted assets while, an external source of
finance is provided by people or institutions outside the business that creates debt and requires
payment like loans.

Sources of Funds for Personal Finance:

 Family
 Friends and relatives
 Fund Raising Activities
 Pawnshops
 Loan Shark (5/6)
 Banks

Forms of Business organizations:

A. As to Ownership.

1. Sole Proprietorship – A business owned by one person and operated for his or her own profit.
2. Partnership – A business owned by two or more people and operated for profit.
3. Corporation – An entity created by law owned by shareholders.
4. Cooperative – A business organization with a voluntary association of members for their
common benefits.

B. As to Nature/purpose.

1. Service – rendering service as catered in barbershops, spa and massage clinics,

dental/medical clinics, laundry shops, among others.
2. Trading/Merchandising – buying and selling goods like sari-sari store, hardware stores,
department stores, among others.
3. Manufacturing – converting raw material into finished products like in shoes and bags
manufacturing, furniture manufacturing, chicharon or native delicacies manufacturing.
4. Banking and finance – deals with institutions involved in lending and borrowing. These are
banks, pawnshops, money lenders, insurance companies, credit card companies, among
others.
5. Mining/extractive industries – extract natural resources like gold mining companies, gravel
and sand quarrying, among others.
6. Construction companies – engaged in road building, house building, construction of different
buildings like schools, hospitals, commercial apartments, among others.
7. Genetic industries – involved in the production, multiplication, and reproduction of certain
species of plants and animals like agriculture, fishing, animal husbandry, poultry farming,
plant nurseries, among others.
Financial Resources – the funds of a business which are provided by the owner or by the creditors.
The resources of the business are largely intended to handle the current operating activities and the
other activities that will have long-term effects.

Financial Investments – resources that are expected to provide income and achieve appreciation
or growth of the business. The financial benefits that are usually derived from financial investments
come in the form of interest and bonds.

Financial Expenditures – cover the operating expenditures and the capital expenditures. Operating
expenditures are period costs that include business expenses such as salaries, electricity and
water, traveling expenses, and the like. Capital expenditures involve the acquisition or construction
of buildings, machinery, processing plant, and land.

Areas of Finance:

Finance is broadly classified into two:

1. Private Finance – the management of financial resources of private individuals, non-

governmental organizations, and private organizations.
2. Public finance – the allocation of government income generated from either taxation or
borrowings and the government expenditure based on the approved national and local
appropriation or budget.

Private Finance is subdivided into:

1. Business Finance – focuses on the handling and management of financial resources of a

business organization.
2. Personal Finance – the management of personal resources of an individual. The income of
an individual is sourced from compensation, exercise of profession, or business income as a
sole proprietor. Income is allocated based on the individual’s personal need.

Business Finance is further subdivided into:

1. Financial Management – focuses on capital budgeting decision or investment decision on

the acquisition of assets and its corresponding financing scheme.
2. Capital Market – studies the different financial institutions and their functions that provide
assistance to both private and public borrowers of funds.
3. Financial Investment – includes business decisions about the value and price of stocks and
bonds, portfolio analysis, market analysis, security analysis, and behavior of the investors.
Financial Management – deals with decisions that are supposed to maximize the value of
shareholders’ wealth. The goal of financial management is to maximize the value of shares of stocks.

- Managers of a corporation are responsible for making the decisions for the company that
would lead towards share holders’ wealth maximization.

Finance in a Business Organization

Figure 1: Illustration of the Corporate Organization Structure

 The Shareholders elect the Board of Directors (BOD). Each share is equal to one voting right.
They buy shares to earn a profit in a form of dividend.
 The Board of Directors is the highest position in a corporation. Some of their
responsibilities are providing direction of the company, setting the policies on investments,
approving the company’s strategies, goals, and budgets, appointing, and removing members
of the top management.
 The President supervises the company’s operations and ensures that the strategies are well
executed and planned. He/She also performs all areas of management such as planning,
organizing, staffing, directing, controlling, and evaluating.
 Some of the responsibilities of Vice President for Sales and Marketing are formulating
business strategies and plans, directing and coordinating sales, making environmental
scanning or research that will allow the company to increase sales, or identifying new market
opportunities, analyzing and assessing the effectiveness and efficiency of the plans, methods
and strategies applied and establishing a good relationship with customers and distributors.
 The Vice President for Administration is responsible for the coordination of the different
departments, providing assistance to the other department by determining the staff needed
and assisting other departments in hiring employees and in payroll preparation.
  The Vice President for Production makes sure that the production meets the demand,
finds ways to minimize cost in producing a competitive quality product, maximizes the
utilization of the production facilities and solves production issues.
 The Vice President for Finance makes decisions including planning, acquiring and
utilization of funds. The functions of the Finance Manager are investing decisions, financing
decisions, operating decisions, and declaring dividends.
o Investing decisions deals with managing the assets of the firms. Some of the
examples of investment decisions are the allocation of funds, determination of the
funds that a firm can put into investment, evaluation, and selection of capital
investment proposal.
o Financing decisions includes making decisions on how to finance the long-term
investments (expansions or acquisition of new land) and working capital which deals
with the day-to-day operations of the company (payment of rent and utilities,
purchase of raw materials). The finance manager must determine the right capital
structure of the company. Capital structure refers to how much the total asset is
financed by the debt (like loans) or equity (like stocks or bonds).
o Operating decisions deals with working capital management. Working capital refers
to short-term assets and short-term liabilities. Inventory, receivables, cash, and short-
term investments are examples of short-term assets. Accounts payable and short-term
investments are examples of short-term liabilities. Working capital management helps
the firm to ensure that the firm has sufficient resources to finance the day-to-day
operations but, if the management is aggressive, they will take the risk to use either
long-term or short-term sources or even the combination of the sources. (Later on, this
will be discussed in other modules.)
o Declaration of dividends refers to the determination of how much dividends are to
be distributed to the shareholders, frequency of payments and amounts to be retained
by the firm. Dividend is a portion of profit or payment made by a corporation to its
shareholders.
o There are certain conditions before a company can declare dividends:
(1) The company must have enough retained earnings (accumulated profits) to support
cash dividend declaration.
(2) They must have enough cash.

Both the treasurer and the controller report to the Vice President for Finance. The treasurer
is responsible in managing the cash and credit, financial planning and capital expenditures. The
controller handles tax payments, financial accounting and management information systems.

The organizational structure of the firm depends on the size and nature of the firm. Every
department in the organization needs funds to function well. Since finance is needed in all parts of
the organization, the finance manager must communicate with other department managers to
achieve the goals of the company.

Functions of a Financial Manager:

- Financing – to determine the appropriate capital structure of the company and to raise funds
from debt and equity.
- Investing – investments may either be short term or long term.
 - Operating – determine how to finance working capital accounts such as accounts receivables
and inventories (short term vs. long term)

- Divided Policies – determine when the company should declare cash dividends.

LESSON 2 – Financial Institutions, Financial Instrument, and Financial Market

The Financial Institutions

The role of financial institutions in the money flow is shown below. See Figure 3.

Figure 3: The Role of Financial Institutions in the Money Flow

The flow of money begins with the depositor who opens a bank account and earns interest
from the account. In exchange, these funds are lent by the banks to businesses. They are borrowers
who want to start up a new business, a new product, expand a business, or find another
investment opportunity. When the business earns profit, the borrower of the funds will pay interest
on the loan, and the depositor receives an interest in his/her bank account.
 The financial institution’s role is to act as a financial intermediary. A financial intermediary
serve as a link between the depositor who has the money and the lender who needs money.
Financial institutions include commercial banks, universal banks, investment banks, investment
companies, finance companies, life and non-life insurance companies, mutual fund companies, and
private equity firms.

Most funds, especially public funds, are looking for investment opportunities that will
sustain their requirements for about five years or more, that is, long-term, and this is to separate
certain investor requirements from fast returns.

Financial management is managing financial matters including analysis of statements,

assessment, or investment opportunities, which happens before one starts investing and acquiring
funds from different sources.

The Key Individual Roles

1. The Depositor Who Has the Funds

The depositor is the person who has the money and puts in a savings account with a bank
that pools this together with the savings from other depositors. He/she saves money in a
bank because he/she wants to achieve things in life, such as a new house, a new car or even
a small business. His/her money also earns interest in the bank.

2. The Borrower Who Needs the Funds

The borrower is the one who needs funds and borrows it from a bank. He/she knows where
to use the funds such as starting up a new business, purchasing new equipment, expanding
his/her business, or investing in other financial instruments.

Financial Instruments and Financial Markets

Financial instruments are the tools that help a business’ daily operations and help the
finance manager handles his/her cash, his/her short-term operating requirements, and long-term
business requirements.

Money market instruments are funds available for a short time (1 year or less than a year).
They are available most of the time and do not provide very high returns. Table 1 is a list of the
different market instruments and their characteristics.
 Table 1. The Different Money Market Instruments and their Characteristics

The borrower can also use long-term debts for his/her business needs. However, the interest
rates are higher than money market instruments. Bond is an example of long-term debt. It is a
security reflecting the debts of a government’s or business’ debt promising to pay a fixed interest to
the bondholder for a definite time.

A note is another example of long-term debt that has a longer term than a money market
instrument. Notes are similar to bonds that have regular interest payments and have a specified
maturity term.

Table 2. Long-term Debt Instrument

 Stocks are types of security that represent ownership in a corporation and a claim on part of
the corporation’s assets and earnings. The two main types of stocks are common and preferred.

Table 3. Preferred and Common Stock

Financial Market

Financial Markets are the meeting places of suppliers and users of various types of funds that can
make transactions directly.

1. Primary Market – refers to financial market in which buyers and sellers negotiate and
transact business directly without an intermediary.
o Public offering is the sale of new securities to the general public and the first
offering of stock is called IPO or Initial Public Offering.
o Private placement is the sale of a new security to a private or specific buyer.

2. Secondary Market – refers to financial market where previously issued securities (such as
bond, notes and shares) are bought and sold.

3. Money markets are venues wherein securities with short-term maturities (1 year or less) are
borrowed or loaned. Capital markets are financial markets for stocks for a long-term period
(one year or longer).

Different Types of Financial Institutions

A financial institution can be a bank or nonbank.

Different kinds of banks:

1. Thrift Banks
Thrift banks are deposit-taking financial institutions that extend credit to the
consumer market that is in the countryside or rural areas.
 2. Commercial Banks
Commercial banks are mainly deposit-taking financial institutions that extend credit
to the retail and consumer market, and their transactions are usually many but small, using
the local currency.

They collect and secure the funds of the depositors. Savings and checking accounts
provide a fast and efficient way for bank clients to access their money and use the money to
pay bills and other short-term investments such as utility bills, education fees, and other
expenses.

They lend money of the depositors to small and medium businesses in exchange with
interest to be paid regularly for the use of the funds.

The interest paid to depositors and the rate earned from borrowers will pay the
banking cost such as employees’ salaries, office rent, electricity, and other business-related
costs.

3. Universal Banks
Universal banks lend money to multinational companies. The transactions are larger
than commercial banks and denominated in multicurrencies not just to the local currency.
They are like commercial banks but mostly their clients are larger corporations. They also
offer other financial services due to an expanded license to engage with clients.

4. Investment Banks/Companies
Investment banks provide loans to big corporations and governments and can raise
funds through bond issuances and initial public offerings. Investment banks also provide
funds to businesses.

How investment banks raised funds from the public:

a. Identify the business who needs financing.
b. Talk and negotiate with the investors the amount needed to be raised, kind of
denominations to use, investment rate to pay the investing public, and the fee to
charge for putting all the fund raising and lending together.
c. Execute the fund raising once the agreement is done.
d. Monitor the financial stability of the issuer.
e. Monitor the payments to investor.

The nonbank institutions that raise and lend funds:

1. Leasing Companies
Leasing companies extend financing to companies that need funds for their business.
They are not banks and are not regulated by central bank.

2. Investment Companies
Investment companies perform similar functions as banks in the manner that they
can provide financing to companies or raise funds through bonds or Initial Public Offerings.
They are regulated by the Securities and Exchange Commission (SEC).

3. Mutual Funds
Mutual funds are types of investments or funds of small investors pooled together and
managed to be able to generate maximum returns.
 4. Insurance Companies
Insurance companies sell life and non-life insurance products that offer security
during times of death, illness, accident, and damage to property. Individuals buy insurance
protection with insurance premiums. The insurance companies use these payments to invest
in stocks, bonds, real estate, and mortgages. The proceeds will be the payment to the insured
individual.

5. Private Equity Funds

Private equity funds are managed by private fund managers or investors, allowing
owners to invest more aggressively in the financial markets.

The Flow of Money and Role of the Financial Manager

The flow of funds to businesses begins with the source of funds, the saver or lender, who has
the money, saves, or deposits with the bank of any financial institution. The financial institutions or
banks look for outlets to increase the money. The businessman need money for his/her projects, so
he/she borrow money from the depositor. The borrower pays interest. The goal of finance is to
maximize profit, so it is expected that the finance manager will invest the money into new projects
or use this wisely. He/She can use the money to pay the company’s loan, use for the operation of
the business or put it in investments.

What is a worthwhile business?

A worthwhile business is a business that achieves the objective of financial soundness,

sustainability, competitiveness, and nation-building. The financial manager's role is to ensure that
the entire cash flow happens and is completed up to interest payments on the borrowed loan after
money is invested in a worthwhile business.

Before credit is provided or extended, there is an evaluation of the business done to ensure
that the money borrowed is paid back on time. What kind of evaluations and test are done? What
are the important questions asked? See Figure 4.
Figure 4. Evaluation of the Business