BUSINESS FINANCE 1

Learning Competencies:
Explain the major role of financial management and the different individuals involved
(ABM_BF12-IIIa-1)
 define Finance and Financial Management;
 explain the major role of financial management and the different individuals involved;
 identify the primary activities of financial manager; and
 describe how the financial manager helps in achieving the goal of the organization.

Lesson 1: Overview of Financial Management

According to Gitman and Zutter (2012), “Finance can be defined as the science and art 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.”

Finance is a process that includes raising money or resources and allocating them effectively and
efficiently to achieve the firm’s goals or objectives. It includes financial management, the study of investment,
and the study of institutions and markets. Money is needed by the firm to continue its operations, expansion,
replacement of new machinery and equipment, payments, acquisition of new investment, and internal growth.

According to Cayanan and Borja (2017), “Financial management deals with decisions that are supposed
to maximize the value of shareholders’ wealth.” Financial management is a decision-making process that includes
planning, analysis, utilization, and acquisition of funds in order to achieve the desired goals of the business. Risk
and return are part of managing a business. A thorough plan and analysis should be done to avoid or reduce risks
and to have a good return.

The goal of financial management is to maximize the wealth of the shareholders. Its aim is to make
money and add value to the investors and to the firm.

Investors buy stocks because they want something in return. More investors will create more funds and
more jobs. Maximizing the shareholders’ wealth is not that easy; a lot of things should be considered, and they
need to satisfy different stakeholders. To gain profit, the business should make customers happy. They must treat
their employees well like customers to become more productive and trustworthy. They should pay their financial
obligations with their creditors and suppliers on time so they can establish a good relationship. They must pay
their financial obligation on time. Firms must also pay attention to the government and environmental issues.
They must comply with the government and legal requirements. They must see that they will not have a bad
effect on the environment.

Financial management includes planning, organizing, controlling, and directing to acquire and utilize
the funds or resources effectively and efficiently. Every activity of the finance manager should be according to
plan. It should be organized, controlled, monitored, and evaluated.

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.

The Corporate Organization Structure

The figure below shows a typical organizational chart

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Illustration of the Corporate Organization Structure

Adopted from Cayanan (2017)

 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 shortterm 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.
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.
 BUSINESS FINANCE 3

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.

The Role of the Finance Manager

According to Cabrera (2017), “In striving to maximize owners’ or shareholders ‘wealth, the financial
manager makes decisions involving planning, acquiring, and utilizing funds which involve a set of risk-return
trade-offs.” Those risks or returns would have an impact on the market value of the firm that will lead to the
shareholder’s wealth maximization or downfall of the firm if no proper decisions were made, but some of the
factors that affect the market’s price of the firm’s shares are beyond the control of the management. Thus, it is the
responsibility of the financial manager to make decisions in allocating the funds or resources properly, finding the
best alternatives for funding the company, and creating a policy in distributing the dividends of the investors in
line with the organization’s objectives.

The Role of Financial Manager

TOPIC QUESTIONS
1. Why do we study financial management? Enumerate its benefits to the success of a business.
2. What is the role of finance in the development of an economy?
3. How does the financial manager affect the firm’s overall business strategies?
4. Supposed that you have saved Php. 100, 000.00. How will you manage your finances wisely?
5. Why is it important to understand the basics of financial planning?
6. Explain why shareholder wealth maximization should be the overriding objective of management.
Learning Competencies:
Distinguish a financial institution from a financial instrument and a financial market (ABM_BF12-IIIa-b-2)
 define financial institutions, financial market, and financial instruments; and
 identify the types of financial institutions, financial market, and financial instruments.

Lesson 2: Financial Institutions, Financial Instruments and Financial Markets

The Financial Institutions

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 serves 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.
 BUSINESS FINANCE 4

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 it 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’s daily operations and help the finance manager
handle 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.

Money Market Debts

Financial Instruments Characteristics
• issued by the government
Treasury bills (T-bills) • maturity within a year
• not risky, because the government must make an effort to pay
• issued by a financially sound business to fund
investment in inventories and receivables.
Commercial papers
• maturity is about nine months
• generally low default risk as a business has a good credit standing
• issued by banks or mutual funds companies
• maturity date is not specific
Money market funds • the degree of default risk is low
• usually invested in money market instruments, commercial papers, and
treasuries
• issued by banks, credits unions, and finance companies
Consumer credit,
• the maturity date varies
credit card debt
• default risk varies
Figure 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. A bond is an example of long-term debt. It is a security reflecting the
debts of a government 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 a specified maturity term.
 BUSINESS FINANCE 5

Financial Instruments
Treasury notes and
bonds
Federal agency debt
Municipal bonds, local
government bonds
Corporate bonds
Long-Term Debts
Characteristics
• issued by the government
• matures in two, five, or ten years or more
• no default risk (The government exerts effort to pay.)
• bonds prices usually fall becoming less attractive as interest rates in the market
rise
• not applicable in the Philippine setting (a United States type of long-term debt.)
• issued by federal agencies and it is similar to treasuries
• long-term maturity (i.e. up to thirty years)
• low default risk
• issued by the local government
• long-term maturity (i.e. up to thirty years)
• riskier than government securities
• issued by corporations
• mature in forty years
• riskier than government securities and rely on the financial soundness of the
company
Figure 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.
Financial Instruments Characteristics
• issued by the corporation in exchange of ownership
• has no maturity date
Preferred stock • pay dividends when declared
(Preference share) • riskier than corporate bonds
• has no voting rights
• has preference over common stocks in asset liquidation
• units of ownership in a public corporation
• pays dividends when declared
Common stock • owners are entitled to vote on the selection of directors and other important
(Ordinary share) matters
• common stockholders enjoy potential profits from the capital appreciation of
their stock.
Figure 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 the financial market in which buyers and sellers negotiate and transact
business directly without an intermediary.
 Public offering is the sale of new securities to the general public and the first offering of stock is
called an IPO or Initial Public Offering.
 Private placement is the sale of a new security to a private or specific buyer.
2. Secondary Market – refers to the financial market where previously issued securities (such as bonds,
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.
 BUSINESS FINANCE 6

Different kinds of banks:

1. 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 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 lend money to multinational companies. The transactions are larger than commercial
banks and denominated in multi-currencies not just 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 Companies 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 extend financing to companies that need funds for their business. They are not banks
and are not regulated by central bank.
2. 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 are types of investments or funds of small investors pooled together and managed to be
able to generate maximum returns.
4. 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 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. Financial institutions or banks look for outlets to
increase the money. The businessman needs money for his/her projects, so he/she borrows 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.

TOPIC QUESTIONS
 BUSINESS FINANCE 7

1. Distinguish financial institutions from financial instruments and financial markets.

2. Explain the flow of funds within an organization through and from the enterprise and the role of financial
manager.

Learning Competencies:
Identify the steps in the financial planning process (ABM_BF12-IIIc-d-10)
 define financial planning;
 explain the importance of financial planning; and
 illustrate the financial planning process.

Lesson 3: The Financial Planning Tools and Concepts

Financial planning is the process of deciding how an organization can accomplish its financial goals and
objectives. It is divided into:
1. the long-term financial plan, also known as the strategic financial plan and
2. the short-term financial plan, also known as the operating financial plan.

Importance of Financial Planning

1. Financial planning helps managers assess the impact of the strategy or actions on their company’s
financial position, cash flows, and earnings and if there is a need for additional financing.
2. It helps the company in the survival when uncertainties come along. Risks are calculated and alternatives
can be done. Through financial plans, the firm can adapt to the changes happening in their environment.
3. It gives directions to the organization. Since plans are made, the firm can make necessary actions.

Steps in Financial Planning Process

1. Set goals or objectives. The goals of a company can be divided into:

short-term goals (1 year)
 BUSINESS FINANCE 8

mid-term goals (3-5 years)

long-term goals (5-10 years or even longer)
Long-term goals set the company's direction. Short-term goals are the specific steps or actions that will
ultimately achieve the company's long-term goals.
Vision describes what a company wants to become and mission is how the company will achieve its vision.

2. Identify the resources needed. Resources comprise production capacity, human resources, and financial
resources.

3. Identify a goal that is related to the tasks. The management must find out how to achieve the goal. For
example, if they want to increase sales, they can train their sales agent to become more skilled in dealing
with clients. They can also make sales promotions as a marketing strategy.

4. Assign the task to an accountable and responsible individual or team and have a timeline. After identifying
the task to achieve the goal, the company must identify who will be accountable for the activity. There
should be a specific timeline for it.

5. Establish an evaluation system for monitoring and controlling. The management must establish a process
that allows them to supervise the plan. This can be done by comparing the budgets and projecting financial
statements with the actual results.
6. Determine contingency plans. The management has alternative plans to minimize the risk or bad effect to the
company.

A contingency plan is an alternative plan of an organization to respond efficiently to a future event or

situation that may or may not happen. Budgets and projected financial statements are also considered in
contingency planning.

TOPIC QUESTIONS:
1. Define financial planning using your own words. (1 to 2 sentences)
2. Enumerate the different steps in planning
3. Explain the importance of financial planning. (1 to 2 sentences)

Learning Competencies:
Illustrate the formula and format for the preparation of budgets and projected financial statement (ABM_BF12-
IIIc-d11)
 BUSINESS FINANCE 9

Lesson 4: Budget Preparation and Projected Financial Statements

Budgeting
A budget is an estimate of costs, revenues, and resources over a specified period, reflecting a reading of
future financial conditions and goals. Sales budget, production budget, operating budget and cash budget are the
budgets that need to be prepared.

Sales Budget
It provides the estimated amount of money based on the volume of products that a company proposes to
sell in the future.
In forecasting the financial statements, the most important statement account is sales because almost all
of the accounts in the financial statements are affected by it. Cost of sales and gross profit are examples
of accounts that are affected by sales.
 Sales Revenue=Units to be sold x Unit Selling Price
The finance manager must consider the internal and external factors in preparing sales budget.

External Factors Internal Factors

 Gross Domestic Product (GDP) growth rate  pricing
 income tax rates  promotional activities
 inflation  distribution
 interest rate  production capacity
 foreign exchange rate  management styles
 developments in the industry  financial capability/resources of the company
 competition  reputation
 economic crisis
 regulatory environment
 political crisis
Table 1: Factors that Influence Sales

These external factors like interest rates, GDP, income tax rate, and inflation should be considered to
forecast sales. They can affect the sales of the company. Even a crisis should be considered as the effect of
Covid-19. Many companies closed down and many people lost their jobs. As a result, the company's sales can be
affected because the purchasing power of the people decreases since they lost their job.
Internal factors should also be considered in preparing the sales budget. You cannot produce thousands of
units if you only have 3 production staff.
Example: The required production of ABC Corporation in the first quarter is 200,000 units. The units increased
by 10% per quarter. The selling price per unit is Php 5.00.

Production Budget
 It provides information with respect to the number of units that should be produced over a given
accounting period based on expected sales and targeted level of ending inventories.
 Required Production in Units=Expected Sales + Target Ending Inventories - Beginning Inventories
Example:
Determine the units to be produced by ABC Corporation in 2020.
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Projected Units 200,000 220,000 240,000 260,000
Target Level Ending Inventories 22,000 24,000 26,000 28,000
 BUSINESS FINANCE 10

The beginning inventory is 20,000 units.

Table 2. ABC Corporation Production Budget

In order to get the production units, add the target level of ending inventories and then less the beginning
inventories.

Note that the ending inventory of the first quarter (22,000) is the beginning inventory in the second quarter. The
same can be seen in the quarters that follow. However, the ending inventory for the year is the same as the fourth
quarter and the beginning inventory for the year is the same as that of the first quarter.

Operating Budget
 It is made to estimate how much their revenue and expenses would be within a year. It is composed of the
variable and fixed costs needed to run the operations of the business-like wages and salaries of personnel,
tax payments, interest payments, and rent payments.

Cash Budget
 It displays the expected cash receipts and disbursements for an accounting period. It is prepared on a
monthly or quarterly basis for a year.
 The cash budget is divided into three parts: cash receipts, cash disbursements, excess cash balance, or
required total financing.

Parts of the cash budget are as follows:

1. Cash receipts- These compose of collections from receivables, proceeds from loans, issuance of new
shares of stocks, and advances from the stockholders.
2. Cash disbursements- These include payments to suppliers and other service providers, loans, and cash
dividends.
3. Excess cash balance or required total financing- This part of the cash budget shows possible funding
requirements. If the company has excess cash, it is a good indicator that it can pay an existing loan or put
it in an investment. If there is no excess cash, the company must make a plan where to get funds.

Example: The president of ABC Corporation wants to find out if the company has enough cash to pay the
company’s loan worth Php 300,000.00 by the end of 2020.

a. The projected quarterly sales for the year 2020 are as follows:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
1,010,000 1,110,000 1,210,000 1,310,000

The fourth quarter sales in 2019 were Php 900,000.00. Eighty-five percent (85%) of the sales are collected in the
Quarter 1 of the sales. The remaining fifteen percent (15%) is collected in the following quarter.

b. Assume that the operating expenses for each quarter are as follows
Quarter 1 Quarter 2 Quarter 3 Quarter 4
101,000 111,000 121,000 131,000

c. Cost of sales is 75% of sales

d. Interest expenses paid every quarter is Php 15,000.00
e. Income tax rate is 30%
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These are the income taxes to be paid every quarter.

Quarter 1 Quarter 2 Quarter 3 Quarter 4
30,000 45,000 50,000 55,000

f. Expected cash balance at the end of 2019 is about Php 40,000.00. For 2020, target cash is raised to Php
100,000.00 because of expected increase in sales.

To compute for the cash budget, follow these steps:

 Compute for the cash receipts. Identify how much will be collected from the sales.
a. Multiply the projected sales per quarter by the percentages of sales collection
b. Multiply the projected sales per quarter by the remaining percentages of sales collection. Use the
last quarter sales of last year for the first quarter. Then use Quarter 1 to Quarter 3 sales for year
2020
c. Add the Quarter of Sale and the Quarter after Sale

2. Compute for the cash disbursements. Identify all the payments to be made and add all expenses.

3. Subtract the cash disbursement from the cash receipts to get the net cash flow.

4. Add the beginning cash balance and then subtract the minimum cash balance. If the minimum cash balance is
less than the ending cash balance, the firm has excess cash. If the minimum cash balance is greater than the
ending cash balance, the firm requires financing.

Projected Financial Statement

The projected financial statement is important in planning to forecast the outcome of the organization in
future periods, assess the standing of the business, and budget preparation. It will help in evaluating the additional
 BUSINESS FINANCE 12

assets/funds needed in the business. It will also serve as a basis for the business if it can pay its financial
obligations.

The following are the steps to be followed in projecting financial statements:

Step 1. Forecast the Statement of Comprehensive Income (Income Statement).

 Forecast sales.
 Forecast cost of sales and operating expenses. To get the cost of sales, use the average cost of sales over
the historical data analyzed. Find out which are variable expenses and fixed expenses.
 Forecast net income and retained earnings. (There should be information on income taxes and how much
financing cost a company will have to forecast net income.)

Step 2. Forecast the Statement of Financial Position and Statement of Cash Flows.
 Determine SFP accounts that will be affected or associated with sales. (Cash, AR, inventories, AP, and
accrued expenses payable)
 Determine the external funds needed. The projected statement of financial position has to be balanced so
EFN is computed.
EFN=Change in Total Assets-(Change in Total Liabilities + Total Change in Stockholder’s Equity)
+ EFN, means that the company needs more funds
- EFN, means that the company has excess cash.

Step 3. Find out how to finance EFN.

 After computing the EFN, the management must determine how to finance the company. They can raise
the funds through debt(borrowing from the bank as notes payable) or equity (through stocks and bonds)
or it can be the combination of the instruments.

To further understand the lesson, let us have an example.

Example: The president of ABCD Company asked the finance manager to prepare the projected financial
statements of the company. The accounts needed are shown below.

ABCD Company
Projected Statement of Comprehensive Income
For the Year Ending December 31, 2019
Net Sales Php 54,705,675.00
Cost of Sales 41,954,730.00
Gross Profit 12,750,945.00
Operating Expenses 8,958,213.00
Operating Income 3,792,732.00
Interest Expense 250,000.00
Income before Taxes 3,542,732.00
Taxes 1,062,820.00
Net Income Php 2,479,912.00

Financial Accounts in 2019 Amount

Cash Php 2,000,000.00
Receivables 2,800,500.00
Inventories 5,140,213.00
Other Current Assets 1,500,000.00
PPE 12,400,000.00
Other Noncurrent Assets 900,500.00
Trades Payable 5,550,000.00
Current portion of Long-term Debt 2,000,000.00
Long-term debt, Net of Current 2,000,000.00
Retained Earnings 5,043,216.00
 BUSINESS FINANCE 13

Other Current Liabilities 90,000.00

Capital Stock 9,000,000.00
Total Assets 23,840,713.00
Total Liabilities 10,519,207.00
Total Stockholder’ Equity Php 13,321,506.00

a. Sales are expected to increase by 10% in 2020 from the 2019 sales level. The sales of the company
increased by 10% annually from 2015 to 2019.
b. The cost of sales, cash, receivables, inventories, other current assets, and trade payable are expected to
change with sales based on the financial statements in 2019. The variable operating expense is 8% of
sales. The depreciation expense is 10% of the gross beginning balance of property, plant, and equipment.
The gross balance of PPE was Php 30,000,000.00 (December 31, 2019). The new PPE for 2020 is Php
6,000,000.00. The PPE acquired in the first half of the year will depreciate for one full year.
c. There are two-long term loans as of December 31, 2019. Both have an annual interest rate of 10%. The
first loan will mature on June 30, 2020. Thus, the loan amounting to Php 1,250,000.00 has to be paid on
or before June 30, 2020. The second loan amounting to Php 3,000,000.00 which was incurred on
December 31, 2019, is paid at the rate of Php 500,000.00principal balance every June 30 and December
31. New loans of Php 3,000,000.00 will be incurred on December 31, 2020, payable at the rate of Php
500,000.00 every June 30 and December 31. Annual interest rate is expected at 10%.
d. The income tax rate is 30%. 75% of the income tax payable will be paid in 2020 while the balance will be
paid in 2021.
e. Other noncurrent assets and other current liabilities will remain unchanged.
f. Cash dividends of Php 2,000,000.00 will be paid in 2020.
g. Assume that the current portion of long-term debt amounts to Php 2,000,000.00 and the net of long-term
debt amounts to Php 3,500,000.00 for the year 2020.

Solution:
ABCD Company
Projected Statement of Comprehensive Income
For the Year Ending December 31, 2020
Net Sales Php 60,176,243.00
Cost of Sales 46,150,203.00
Gross Profit 14,026,040.00
Operating Expenses 8,414,099.00
Operating Income 5,611,941.00
Interest Expense 168,750.00
Income before Taxes 5,443,191.00
Taxes 1,632,957.00
Net Income Php 3,810,234.00

Computation:

Projected Net Sales in 2020

= Net Sales in 2019 x (1+Expected increase in Sales Percentage)
= Php 54,705, 675 x 1.10
= Php 60,176,243.00

Projected Cost of Sales in 2020

Cost of Sales∈2019
=( )x Net Sales in 2020
Net Sales∈2019
Php 41,954,730.00
=( )x Php 60, 176, 243.00
Php54,705,675.00
= Php 46,150,203.00
 BUSINESS FINANCE 14

Taxes
= Income Before Tax in 2020 x 30%
= Php 5,443,191 x 30%
= Php 1,623,597.00
 BUSINESS FINANCE 15

Computation:
Projected Cash in 2020
Cash∈2019
=( )x Net Sales in 2020
Net Sales∈2019
Php2,000,000.00
=( )x Php 60, 176, 243.00
Php54,705,675.00
= Php 2,200,000.00

Projected Accounts Receivable in 2020

Accounts Receivable∈2019
=( )x Net Sales in 2020
Net Sales∈2019
Php 2,800,000
=( )x Php 60, 176, 243.00
Php54,705,675.00
= Php 3,080,000.00

Projected Inventories in 2020

Inventories∈2019
=( )x Net Sales in 2020
Net Sales∈2019
Php5,140,213.00
=( )x Php 60, 176, 243.00
Php54,705,675.00
= Php 5,654,234.00
 BUSINESS FINANCE 16

Projected Other Current Assets in 2020

Inventories∈2019
=( )x Net Sales in 2020
Net Sales∈2019
Php1,500,000.00
=( )x Php 60, 176, 243.00
Php54,705,675.00
= Php 1,650,000.00

Projected Trades Payable in 2020

Inventories∈2019
=( )x Net Sales in 2020
Net Sales∈2019
Php5,550,000.00
=( )x Php 60, 176, 243.00
Php54,705,675.00
= Php 6,105,000.00

Property Plant and Equipment

= (PPE in 2019 + new PPE acquisition in 2020)- [(gross balance in 2020 + new PPE acquisition in 2020) x
Percentage Depreciation Expense in 2020
= (Php 12,400,000.00 + Php 6,000,000.00) – [(Php 30,000,000+6,000,000.00)] x .10
= Php 18,400,000.00 –Php 3,600,000.00
= Php 14,800,000.00

Projected Income Tax Payable 2020 x 75%

= Php 5,443,191.00 x .75
= Php 4,082,993.00

Projected Retained Earnings in 2020

= (Retained Earnings 2019+Net Income 2020)- Cash Dividends
= (Php 5,043,216.00 + Php 3,810,234.00) – Php 2,000,000.00
= Php 6,853,450.00

Current Portion of Long-term Debt and Long-term Debt

Loan Current Portion Long-term Total
Php 3,000,000.00 Php 1,000,000.00 Php 1,000,000.00 Php 2,000,000.00
Php 3,500,000.00 Php 1,000,000.00 Php 2,500,000.00 Php 3,500,000.00
Total Php 2,000,000.00 Php 3,500,000.00 Php 5,500,000.00

EFN
= Change in Total Assets - (Change in Total Liabilities + Total Change in Stockholder’s Equity)
= Php 4, 444, 021.00 – (Php 5,258,786.00+ Php 2,531,944.00)
= Php 4, 444, 021.00 – Php 7,790,730.00
= - Php 3,345,709.00

2020 2019 Change

Total Assets Php 28,284,734.00 Php 23,840,713.00 Php 4,444,021.00
Total Liabilities Php 15777993.00 Php 10,519,207.00 Php 5,258,786.00
Total S.E. Php 15853450.00 Php 13,321,506.00 Php 2,531,944.00

ABCD Corporation
Projected Statement of Cash Flow
For the Year Ending December 31, 2020

Cash Flows from Operating Activities

Income before Taxes Php 5,443,191.00
Adjustments:
Depreciation 3,600,000.00
Changes in the following accounts:
 BUSINESS FINANCE 17

Decrease (increase) in Accounts Receivable - 279,500.00

Decrease (increase) in Inventories - 514,021.00
Decrease (increase) in Other Current Assets - 150,000.00
Increase (decrease) in Accounts Payable - 555,000.00
Increase (decrease) in Other Current Liabilities -
Cash Flows from Operating Activities 7,544,670.00
Cash Flows from Investing Activities
Acquisition of Property, Plant and Equipment - 6,000,000.00
Acquisition of Other Noncurrent Assets
Cash Flows from Investing Activities - 6,000,000.00
Cash Flows from Financing Activities
Payment of Cash Dividends - 2,000,000.00
Short-term Notes Payable (EFN) -
Loans, Net Payment 1,500,000.00
Cash Flows from Financing Activities - 500,000.00
Net Change in Cash 1,044,670.00
Cash, Beginning 2,000,000.00
Cash, Ending Php 3,044,670.00

Formula:
Changes in Accounts = Accounts in 2019 – Accounts in 2020
Example:
Changes in Accounts Receivable =
Accounts Receivable in 2019 – Accounts Receivable in 2020
= Php 2,800,500.00 – Php 3,080, 000.00
= Php 588,000.00

Learning Competencies:
explain tools in managing cash, receivables, and inventory (ABM_BF12-IIIc-d12)
 BUSINESS FINANCE 18

 describe concepts and tools in working capital management

Lesson 5: Working Capital Management

Working capital management is the proper administration of current assets and liabilities. Good working
capital management enables the firm to pay its financial obligation, establish good relationships with suppliers
and creditors, and improve the earnings of the company.
A working capital management is important because it can improve the business profit. It allows the
company to pay its financial obligations and leads to the growth and survival.

Current assets like cash, accounts receivable, inventories, and prepaid expenses used in the operations of
the business are called working capital. It means that they can be converted into cash, sold, or exchanged. The
amount of resources used in the operations of the business can be affected by current liabilities like trade accounts
payable.

Net working capital is the difference between current assets and

current liabilities.
Net Working capital = Current Assets – Current Liabilities

Example: The total assets of Masipag Corporation amounts to Php 20,000,000.00 and its total current liabilities
amounts to Php 16,000,000.00.

 The working capital of Masipag Corporation is Php 20,000,000.00.

 The net working capital of Masipag Corporation is Php 4,000,000.00
(Php 20,000,000 – Php 16,000,000.00)

Operating Cycle and Cash Conversion Cycle

Operating Cycle = Days of Inventory + Days of Receivable

Where:
Days of Inventory (Inventory Conversion Period) is the average number of days to sell its inventory.

365 days
Days of inventory =
Inventory Turnover Ratio

Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory

Days of Receivable (Receivable Conversion Period) is the time it takes to collect cash from the sale of
the inventory.

365 days
Days of Receivable =
Receivable Turnover Ratio

Net Credit Sales

Receivable Turnover Ratio =
Average Accounts Receivable

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a
company to convert its investments in inventory and other resources into cash flows from sales.
(investopedia.com)
Cash Conversion Cycle = Operating Cycle – Days of Payable
 BUSINESS FINANCE 19

365 days
Days of Inventory =
Payable Turnover

Net Credit Sales

Payable Turnover Ratio =
Average Accounts Payab ; e

Example:
Accounts Beginning Ending Average
Inventory Php2,500,000.00 Php3,700,000.00 /2 Php3,100,000.00
Accounts Receivable Php 1,950,000.00 Php 2,500,000.00 /2 Php2,225,000.00
Accounts Payable Php900,000.00 Php1,100,000.00 /2 Php1,000,000.00
Net Sales Php15,000,000.00
Cost of Goods Sold Php9,500,000.00

Cost of Goods Sold Php 9,500,000.00

Inventory Turnover Ratio = = = 3.06
Average Inventory Php3,100,000

365 days 365

Days of Inventory = = = 119.28
Inventory Turnover Ratio 3.06

Net Credit Sales Php 15,000,000.00

Receivable Turnover Ratio = = = 6.74
Average Accounts Receivable Php 2,225,000.00

365 days 365

Days of Receivable = = = 54.15
Receivable Turnover Ratio 6.74

Operating cycle = Days of Inventory + Days of Receivable

= 119 + 54
= 173

The operating cycle is 173 days which means that it is longer to recover its inventory. A shorter cycle is preferred
because it means business is more efficient and has enough cash to meet financial obligations. The company must
find ways to decrease its operating cycle.

Net Credit Sales Php 15,000,000.00

Payable Turnover Ratio = = = 15
Average Accounts Payab ; e Php 1,000,000.00

365
Days of Inventory = = 24.33
15

Cash Conversion Cycle = Operating Cycle – Days of Payable

= 173 – 24
= 149 days
 BUSINESS FINANCE 20

It means that the company takes 149 days to get the cash from its investments in inventory and accounts
receivable.

Working Capital Financing Policies

1. Maturity-matching working capital financing policy
The permanent working capital requirements should be financed by long-term sources while temporary
working capital requirements should be financed by short-term sources of financing.

2. Aggressive working capital financing policy

Some of the permanent working capital requirements are financed by short-term sources of financing.
Managers use this kind of policy because long-term sources of funds have a higher cost as compared to short-
term sources of financing. By financing some of the permanent working capital requirements with short-term
sources of financing, the financing cost is minimized, which in turn, improves net income.
But what is the trade off? Since it is short-term, the debt has to be paid soon and the company may not yet
have enough cash by the time the debt matures. This refers to liquidity risk and this risk increases with the
aggressive working capital financing policy.

3. Conservative working capital financing policy

There are of the temporary working capital requirements that are financed by long-term sources of
financing.
Some companies use this policy because they don’t want to be stressed too much and to be focused on
other company’s matter. It can also be their management style. It will be easy for the company to raise funds
(Cayanan and Borja, 2017).

To summarize the financing policy, see the table below:

Financing Policies Permanent Working Capital Temporary Working Capital
Maturity-matching Long-term sources Short-term sources
Aggressive Long-term sources, Short-term sources
short-term sources
Conservative Long-term sources Short-term sources,
long-term sources

Permanent or fixed working capital refers to the minimum level of current assets required by a firm to
continue the operations of the business and to cover up all current liabilities.

Temporary working capital is the difference between net working capital and permanent working capital.
It can help the business survive during the slack season.

Temporary working capital = Net working capital – permanent working capital.

Long-term sources of financing include long-term debt like loan from a bank and equity such as
common stock and preferred stock. Short-term sources include short-term loans from a bank.

Cash Management
Cash management involves the maintenance of a cash and marketable securities investment level which
enables the company to meet its cash requirements and at the same time, optimize the income of idle funds
(Cabrera, 2015).
The objectives of cash management are to meet the financial obligation of the
firm and to avoid losses in the normal operation of the business.

Reasons for Holding Cash

1. Transaction Motive – Cash is needed for the day-to-day operations of the business.
2. Contractual Motive – Some banks require a company to maintain a certain compensating balance for
their deposit accounts and loans.
3. Precautionary Motive – Firms hold cash to be ready in case of unwanted situations such as slowdown of
accounts receivables that may affect the fund for operations.
4. Speculative Motive – A company holds cash for other investment opportunities.
 BUSINESS FINANCE 21

Cash budget is used in determining the cash needs of the company. It shows the projected cash receipts
and cash disbursements for a particular period of time.

Receivables Management
Providing credits to a customer is one way of increasing sales and gaining additional customers. Properly
managing the accounts receivable lets the company continue its operations. To minimize loss from accounts
receivable, the customer must be given credit terms and credit evaluation must likewise be done.

The following 5C’s of credit can be used in credit evaluation.

1. Character – is the borrower’s willingness to pay the loan.
2. Capacity – is the borrower’s ability to pay the loan.
3. Capital – is the borrower’s financial resources.
4. Collateral – is the borrower’s security pledge for the loan payment.
5. Condition – is the current economic or business conditions.

Inventory Management
Inventory is the stocks of the product the business is selling and the parts or raw materials that made up
the product.
Inventory management is very important for manufacturing and merchandising companies especially
companies with perishable products. There should be a sufficient number of inventories to secure the smooth
operations of the business.

The following are the list of internal controls that management should consider in to protect their inventories.
1. Separating the custodial functions from recording functions. The company should not allow the
assignment of custodial functions from recording functions to one person to avoid manipulation of
records.
2. Aging of inventories. It allows the company to decide what to do with slowmoving items. For example,
they can use bundling or buy one take promo.
3. ABC Analysis. This approach categorizes the inventories according to their values. A is considered the
most important inventory or with the highest values, B is considered the average item and C is the least
important or has lower value.

TOPIC QUESTIONS
1. Why is proper management of working capital important to a company’s financial health?
2. What are the three working financing policies? Enumerate and discuss briefly.
3. What are the benefits and importance of cash and accounts receivable management?

Learning Competencies:
identify the bank and nonbank institutions in the vicinity that are possible sources of funds, and enumerate their
requirements and process for loan application (ABM_BF12-IIIe-f-13)
compare and contrast the loan requirements of the different banks and nonbank institutions and cite these
institutions in the locality (ABM_BF12- IIIe-f-14)

Lesson 6: Banking and Nonbanking Institutions

Banks are financial institutions that accept deposits from or offer loans to an individual or entity. Here
are some examples of banks from the website of Bangko Sentral ng Pilipinas (www.bsp.gov.ph);
a. Banco De Oro (BDO),
b. Bank of the Philippine Islands (BPI),
c. Land Bank of the Philippines (LBP), to name a few.
 BUSINESS FINANCE 22

Nonbanking institution, on the other hand, offers bank-like services but cannot accept deposits due to
absence of banking license. Examples of nonbanking institutions are insurance companies, currency exchange,
microloan organizations and pawnshops (The World Bank Group 2020).

Insurance companies offer transfer of risk transactions. In the event of uncertain loss of the business,
insurance may cover the loss for them. Governmentowned insurance providers are GSIS and SSS, and private
insurance providers like Sun Life, Metrobank AXA, BPI PhilAm Life are listed in the Insurance Commission
(Insurance Commission 2018).

Currency exchange is an industry of buying and selling currencies. Examples of financial institutions
listed in BSP Money Service Business are Western Union, Cebuana Lhuillier, Mlhuillier, Villarica Pawnshop and
many other local forex businesses (BSP-List of Money Sevice Business 2020).

Microloan organizations are lending companies or organizations that usually offer small credits to
individual or business. These organizations help small businesses to fund their short-term finances with less
requirements. Examples of microloan organizations (also called microfinancing) are the local cooperatives and
lending or semi-lending companies like Home Credit, GCash, Paymaya and the like. These companies are found
in the List of BSP Supervised Electronic Money Issuers (Bangko Sentral ng Pilipinas 2020)

Pawnshops are institutions that offer quick cash loans or “sanla”. The process is too simple that a pawner
offers a collateral in the form of jewelry (gold, silver, diamond and other precious metals or stones) to loan
money. Examples of these pawnshops listed in the BSP (List of BSP-Supervised Pawnshops 2020) are Cebuana
Lhuillier, Mlhuillier, Palawan Express and Villarica Pawnshop.

In the Philippines, the regulatory agency governing the conducts of financial institutions, whether bank or
nonbank, is the Bangko Sentral ng Pilipinas (BSP). BSP regulates these financial institutions by providing policy
directions in the general use of money, banking, and credit (BSP Overview of Functions and Operations 2015).
Thus, bank protocols, especially on information gathering of a client’s personal and financial information, is ruled
by BSP abiding the rules of Anti Money Laundering Act (AMLA).

Loan Requirements of Banks and Nonbanking Institutions

At some point, a business may consider finding an outsource of funds to finance its operations.
Depending on the amount needed, business relies on financial institutions whether banks or nonbanks, and this
amount of credits may require certain requirements that can range from financial statements, legal/personal
documents, or/and property collaterals.

Business loans can be used in different purposes and whether these funds are used for short-term or long-
term. The loan can be payable in longer terms, example, up to 30 years. The range of credit offered to a client can
be as much amount but will depend on the collateral he/she submitted. In banks, collaterals are in the form of real
properties like land or house and lot. The business may have to submit the land title as a requirement. The
purpose of the loan should be clear because bank requirements may differ from one purpose to another. Example
of these purposes are for franchising, purchase of new equipment, expansion, or construction and for establishing
a new business. They may even require business registrations, depending on the type of business: single
proprietor, partnership, or corporation. Banks assess more loan requirements because they are more concerned
with the business’ capacity and ability to pay. Collective term for these loan purposes is Business Loan or Small-
Medium Enterprise (SME) Loan.

On the other hand, nonbanking institutions also provide loans but unlike banks, they have lighter loan
requirements. They may offer flexible amounts to be loaned with minimum to no collateral acceptance. Under a
microloan, for example, a business may apply for a loan and be approved onsite without the need to disclose the
purpose of taking the loan. However, they have higher interest rates compared to banks. They also have shorter
payable period. The worst can happen that when a business fails, one can be indebted under such big interest.

Whether loans are applied in banks or nonbanks, a business’ financial structure and planning should
always be monitored. Take loan amounts that are only necessary for a project and assess the impact of
amortization payment to the business. There are certain banks which also offer up to P5M without collateral
under certain conditions and subject for approval. These banking and nonbanking institutions have different
 BUSINESS FINANCE 23

mechanisms on how to attract potential clients. Thus, background checking is a business’ preventive tool to
minimize the risk of falling into deep interest payment. Financial analysis, financial ratios and budget
preparations are some tools that can help business utilize its funds wisely.

Below are the loan requirements of banks and nonbanking institutions.

Loan Requirements of Banks

a. Application form – is the details gathered in this form refers to your personal data, income sources and
credibility.
b. Valid personal identification documents – are supporting documents that backup the data presented in the
application form. IDs are classified as primary and secondary, depending on the bank’s list of IDs.
Primary IDs usually are government-issued, photo bearing ID.
c. Financial statements – is usually presented to support credibility of the entity applying for a loan. The
purpose of the loan and/or attractive financial leverage can help ease the application process.
d. Bank statements – are client record of bank transactions which is used to see the liquidity of cash flow of
the business.
e. Certificate of business registration – refers to the overall legality of the business organization and its
operations. Registration may come from Bureau of Internal Revenue (BIR), Mayor’s Permit, Department
of Trade and Industry (DTI), Securities and Exchange Commission (SEC), to name a few.
f. Company profile – may be presented in business proposal form indicating the profile of the business,
purpose of the loan, amount to be loaned and/or the return projections.
g. Collateral documents - include land title, tax declaration, vicinity map, and special power of attorney (if
applicable).

Loan Requirements of Nonbanking Institutions

a. Application form – refers to your personal data, income sources and credibility.
b. Valid personal identification documents – are IDs required in nonbanking institutions which are
classified into primary and secondary which usually require more identification requirements in loans of
big amounts.
c. Credit information/collateral file – are documents offered by the client submitted to and held by a
Custodian.
d. Credit investigation – may be required to determine the credit standing of the applicant and the fair
market value of the collateral being offered.

Loan Application Flow Chart (Yumang, et al. 2016)

Figure 1: Flow Chart of Loan Application

 BUSINESS FINANCE 24

As seen in the flow chart, a borrower will accomplish an application form which contains personal and
business details. Upon submission, the creditor will conduct an interview for a background check to an applicant
regarding his/her credibility, capacity, and ability to pay. The creditor will request additional requirement, if
applicable. If requirements are met and the application is of good will, the creditor will approve the loan or will
be declined if otherwise.

Learning Competencies:
calculate future value and present value of money (ABM_BF12-IIIg-h-18)
d. distinguishing simple and compound interest; and
e. solve exercises and problems in computing for time value of money with the aid of present and future value
tables.
compute loan amortization using mathematical concepts and the present value tables (ABM_BF12-IIIg-h-20)
a. prepare loan amortization tables; and
b. compute loan amortization using mathematical concepts and the present value tables (ABM_BF12-IIIg-h-
20)

Lesson 7: Basic Long-term Financial Concepts

Simple and Compound Interest

Businesses and individuals borrow money if in need of cash. When they borrow money, they incur debt.
The lender earns money through interest and the borrower gets the money he needs but in return, he needs to pay
the money he borrowed plus the interest.

What is the time value of money?

The time value of money (TVM) is the concept that money you have now is
worth more than the identical sum in the future due to its potential earning capacity.
This core principle of finance holds that provided money can earn interest, any
amount of money is worth more the sooner it is received. (Investopedia)
People invest their money to receive returns in the future. The time value
concept helps individuals or businesses to analyze what will be the value of money
in the present and in the future.
The present value is the original amount borrowed, the future value is the
principal plus the total interest earned over a stated period, the interest is the
amount of money paid for the use of borrowed money. Present value and future value
are both involved in the time value of money. Both consider three factors: principal,
interest rate, and time.

Simple Interest
 BUSINESS FINANCE 25

Simple interest is computed based on the principal amount (original amount) and based on the annual
time. It is computed by multiplying together the principal, rate, and time.
I = Prt
Where: I = simple interest
P = principal
r = interest rate
t = time

To find the future value (maturity value) at the end of the term, add the principal amount and the interest
earned.
FV = P + I or FV = P (1+rt)
Example 1: You invested Php 20,000.00 for three years at 5% simple interest rate. How much will you get after
three years?

Solution:
Given: P = Php 20,000.00 r = 5 % or .05 t = 3 years
I = Php 20,000.00 x .05 x 3
= Php 3,000.00
FV = Php 20,000.00 + Php 3,000.00
= Php 23,000.00

Example 2: Alex paid Php 1,537.50 with a loan made 3 months before at 10% simple interest. Find the principal
amount of the loan and the interest generated.

Solution:
Given: FV = Php 1,537.50 r = 10 % or .1 t = 3 months = 3/12 = .25

F
P= I = FV - P
1+ rt
Php 1,537.50
= = Php 1,537.50 – Php1,500.00
1+ ( .1 ) (.25)
= Php 1,500.00 = Php 37.50

Example 3: The interest on a loan of Php 20,000.00 is Php 3,200.00. If the rate is 8%, when is the loan due?

Solution:
Given: P = Php 20,000.00 r = 8 % or .08 I = Php 3,200.00
I
t=
Pr
Php 3,200.00
=
Php 20,000.00(.08)
= 2 years

Example 4: Determine the simple interest rate if an investment of Php 25,000.00 accumulates Php 27,625.00 in
18 months.

Solution:
Given: P = Php 25,000.00 FV = Php 27,625.00 t = 18 months = 1.5 years
I = FV – P
= Php 27,625.00 – Php 25,000.00
= Php 2,625.00
 BUSINESS FINANCE 26

I
r=
Pt
Php 2,625.00
=
Php 25,000.00(1.5)
= .07 or 7%

Compound Interest
Compound interest is simply earning interest on interest. It means that the interest earned is added to the
principal, and the new principal draws interests.
FV = P (1 + r) t
Where: FV = future value
P = principal
r = interest rate
t = time

Example 1: You invested Php 20,000.00 for three years at 5% compound interest rate. How much will you get
after three years?

Solution:
Given: P = Php 20,000.00 r = 5 % or .05 t = 3 years
FV = Php 20,000 (1+.05)3
= Php 20,000.00 (1.05)3
= Php 23,152.50

Instead of computing the value for (1 + r) t, we can use the Future Value Interest Factor (FVIF). The
values for Future Value Interest Factors are shown in Table 1.1 and Table 1.2.
FV = P x FVIF
= Php 20,000.00 x 1.157625 See Table 1.1. The rate is 5%
= Php 23,152.50 and the time is 3 years.

Example 2: Your father paid Php 176,234.17 with a loan made 5 years ago at 12% compound interest. What is
the principal amount of the loan and the interest generated?

Solution:
Given: FV = Php 176,234.17 r = 12 % or .12 t = 5 years
F
P= t
(1+r )
Php 176,234.17
= 5
(1+.12)
= Php 100,000.00

1
Instead of computing the value for we can use the Present Value Interest Factor (PVIF). The values for
(1+r )t
future value interest factors are shown in Table 2.1 and Table 2.2.
P = FV x PVIF
= Php 176,234.17 x 0.567427 See Table 2.2. The rate is 12%
= Php 100,000.03 and the time is 5 years.
 BUSINESS FINANCE 27

Compounding frequency is the number of times an interest is computed on a certain principal in one year. The
i
conversion period per year could be annually, semi-annually, quarterly, or monthly. The equation is j =
m
Where: j = nominal rate
i = interest rate
m = frequency of conversion
Total number of conversion periods n
n = tm = (frequency of conversion) x (time in years)

To find the maturity value, the equation is F = P (1+j) n

Example 3: Find the maturity value and interest if Php 15,000.00 is deposited in a bank at 3% interest
compounded quarterly for five years.

Solution:
Given: P = Php 15,000.00 r = 12 % or .12 t = 5 years m = 4
i 12
j= = = 3% or .03
m 4
n = mt = (4)(5) = 20

Using the PVIF

FV = P(1+ j)n FV = P x FVIF
= Php15,000.00 (1+ .03)20 = Php 15, 000.00 x 1.806111
= Php 27,091.67 = Php 27,091.67
= Php 27,091.67 - Php 15,000.00
= Php 2,091.67 See Table 1.1. The rate is 3% and the
conversion period is 20.

Simple Interest versus Compound Interest

Simple interest is the interest paid on the initial principal only, while compound interest is the interest
paid on both the principal and the amount of interest accumulated in prior periods.
Using the previous example, let us compare simple and compound interest. What did you notice with the
principal amount and the interest amount? In simple interest, the interest is earned on the initial principal only,
but in compound interest, the interest is earned on both the principal and the amount of interest accumulated in
previous periods.

Simple Interest Compound Interest

Year Principal Interest Future Value Principal Interest Future Value
P x .05 P x .05
 BUSINESS FINANCE 28

1 20,000.00 1,000.00 Php21,000.00 20,000.00 1,000.00 Php21,000.00

2 20,000.00 1,000.00 Php22,000.00 21,000.00 1,050.00 Php22,050.00
3 20,000.00 1,000.00 Php23,000.00 22,050.00 1,102.50 Php23,152.50
TOTAL TOTAL
3,000.00 3,152.50
Table 4. Simple Interest versus Compound Interest

Loan Amortization

A loan is the sum of money borrowed that is expected to be paid back with interest. An amortization is
paying the debt with regular payments. A housing loan is an example of an amortizing loan that requires the
borrower to pay. Payments of loans can be annually, semi-annually, quarterly, or monthly. A bond is a form of
loan that can be traded in through the Philippine Dealing and Exchange (PDEX)System.
When debts are paid using the amortization method, it is important to know how much interest is paid
and how much money is reduced in the principal borrowed. This can be seen in an amortization schedule or table.

What is an annuity?
An annuity is a series of payments required for a specific number of periods. An annuity due is when
payments are due at the beginning of each payment period. When the payment appears at the end of each period it
is called an ordinary annuity. The present value of an annuity is computed as:
1
1− t
Present Value of An Annuity = C x (1+r )
r
Where: C = Equal Cash Flow Stream
r = interest rate
t = time
1
1−
Instead of using the formula (1+r )t , you can use the present value interest factor for an ordinary annuity
r
(PVIFA) table found in Table 1.

Example: Find the present value of an annuity if the bank requires Anna to pay Php 10,000.00 at 10%
compounded semi-annually for five years.
1
1− 10
Php 10,000.00 x (1+.05) = Php 77,217.35
.05

To make it easier, you can use the table for present value of an ordinary annuity (PVIFA) found in Table 1.
Php 10,000.00 x 7.721735= Php 77,217.35

The time or period is 10 and the rate is 5%.

Remember those interest payments can be paid annually, semi-annually, quarterly, or monthly, so you have to
adjust the interest rates and time accordingly.

Equal Principal Repayments

Example 1: On January 31, 2020, Matapat Company made a loan of Php 2,400,000.00 from Bank C at the rate of
8% a year. The loan is paid Php 400,000.00 every December 31 and June 30 until the full amount is paid.

Amortization Payment at the Interest Principal Outstanding

Dates end of the period Payment Balance
Php 2,400,000.00
 BUSINESS FINANCE 29

June 30, 2020 Php 496,000.00 Php 96,000.00 Php 400,000.00 Php 2,000,000.00
December 31, 2020 Php 480,000.00 Php 80,000.00 Php 400,000.00 Php 1,600,000.00
June 30, 2021 Php 464,000.00 Php 64,000.00 Php 400,000.00 Php 1,200,000.00
December 31, 2022 Php 448,000.00 Php 48,000.00 Php 400,000.00 Php 800,000.00
June 30, 2022 Php 432,000.00 Php 32,000.00 Php 400,000.00 Php 400,000.00
December 31, 2023 Php 416,000.00 Php 16,000.00 Php 400,000.00 0
Table 1 Amortization Table for Php 2,400,000.00

The following are the steps in constructing the amortization table for equal principal repayments.
1. Find the interest by multiplying the interest rate with the outstanding balance.
I = Php 2,400,000.00 x 10% x (6/12)
= Php 96,000.00
It is 6/12 because the payment is every six months.
2. Find the payment by adding the principal payment with the interest computed.
Payment = Principal + Interest
= Php 400,000.00 + Php 96,000.00
= Php 496,000.00
The payment for June 30, 2020 is Php 496,000.00.
3. Subtract the principal payment from the principal balance.
Php 2,400, 000.00 – Php 400,000.00
= Php 2,000, 000.00
4. Repeat the process up to the last period(time).
Php 2,000, 000.00 x 10% x (6/12) = Php 80,000.00
Php 400,000 + Php 80,000.00 = Php 480,000.00
Php 2,000, 000.00 – Php 400,000.00 = Php 1,600,000.00
The payment for December 31, 2020 is Php 1,600,000.00.
Continue until the principal balance reaches zero.

The amortization schedule shows that as the principal balances decrease, the total payment and
interest payments also decrease.

Equal Regular Payments

Some financial institutions require individuals or businesses to pay equal to regular payments. It means
that the principal and interest are combined.
Present Value of Annuity
1 Present Value of Annuity
The formula to be used is C = 1− 10 or
(1+.05) PVIFA
.05
Example 2:
Let us assume that Matapat Company made a loan of Php 2,400,000.00 to be paid in equal payments for 3 years.
The interest rate is 8% a year compounded semi-annually. The table shows the company’s amortization every six
months.
Payment at the Principal Outstanding
Period Interest
end of the period Payment Balance
0 Php 2,400,000.00
1 Php 457,828.55 Php 96,000.00 Php 361,828.55 Php 2,038,171.45
2 Php 457,828.55 Php 81,526.86 Php 376,301.69 Php 1,661,869.76
3 Php 457,828.55 Php 66,474.79 Php 391,353.76 Php 1,270,516.00
4 Php 457,828.55 Php 50,820.64 Php 407,007.91 Php 863,508.09
5 Php 457,828.55 Php 34,540.32 Php 423,288.23 Php 440,219.86
6 Php 457,828.55 Php 17,608.79 Php 440,219.76 0
Total Php 2,746,971.30 Php 346,971.41 Php 2,399,999.89
Table 2 Amortization Table for Php 2,400,000.00 (Equal Regular Payments)

The following are the steps in constructing the amortization table.

1. Find the payment at the end of the period by using the formula:
 BUSINESS FINANCE 30

Present Value of Annuity

1 Present Value of Annuity
C= 1− 10 or
( 1+.05 ) PVIFA
.05
Period: 6 (3 years, semi-annually) r: 4% (8%/2)
C = Php 2,400,000.00 x 5.242137
C = Php 457,828.55
2. Find the interest on the first period by multiplying the interest rate with the loan.
I = Php 2,400, 000.00 x .04
= Php 96,000.00
Note: 4% is used as interest rate because it is compounded semi-annually.
3. Subtract the interest from the payment to get the principal payment.
Principal Payment = Php 457,828.55 – Php 96,000.00
= Php 361,828.55
4. Find the outstanding balance at the end of each period. Subtract the principal payment from the
outstanding balance.
Php 2,038,171.45 = Php 2,400,000.00 – Php 361,828.55
5. Repeat steps 1, 2, 3 & 4 to compute for the payment at the end of the period, interest rate, principal
payment, and outstanding balance for the second to the last period. You may refer to Table 2.
 BUSINESS FINANCE 31

Learning Competencies:
apply mathematical concepts and tools in computing for finance and investment problems. (ABM_BF12-
IIIg-h-21)

Lesson 8: Capital Budgeting

Capital Budgeting
Capital budgeting is the process that a business uses in evaluating and selecting major projects or
investment. It involves capital investments proposal evaluation, allocation of capital investment funds among
approved projects and programs, and control of such expenditures. Capital expenditures are a
long-term investment.

Steps in Capital Budgeting

Terms related to capital budgeting:

1. Exclusive Projects
a. Independent projects do not compete with other projects.
Example: Project Proposal A is for increasing the sales volume of
Product A. Project Proposal B is for the opening of a new outlet in Mindanao.
b. Mutually exclusive projects compete with other projects and the approval of one eliminates the other
projects.
Example: Project Proposals A and B are presented to increase the sales volume of the product. If
Project Proposal A is accepted, Project B will be eliminated.

2. Capital Rationing and Unlimited Funds

a. The business with capital rationing will choose a project with the best opportunities.
b. If the business has unlimited funds, it will accept all the projects that pass the risk-return criteria.

3. Cash Returns
These are the net cash inflows one expects to get when the business or project has already started.

Tools in Capital Budgeting

1. Payback Method
It is a method that evaluates a project by measuring the time (usually expressed in years) it will take to
recover the initial investments.
 BUSINESS FINANCE 32

Even Cash Flow

Example 1: ABCD Company is considering a project requiring an initial investment of Php 120,000.00. The project is
expected to realize annual cash returns of Php 25,000.00 for 6 years. Calculate the payback period of the project.
Payback period = Initial Investment / Annual Cash returns
= Php 120,000.00 / Php 25,000.00
= 4.8 years.
In this example, ABCD Company will accept the project because the payback period is 4.8 years shorter than 6
years.

Uneven Cash Returns

When the cash returns are uneven, the payback period is computed by adding the cash returns until the
total is equal to the investment.
Example 2: ABCD Company is planning to undertake another project with an initial investment of Php 100,000.00. It is
expected to receive net cash returns of Php 25,000.00 in Year 1; Php 30,000.00 in Year 2; Php 35,000.00 in Year 3; Php
40,000.00 in Year 4; and Php 45,000.00 in Year 5.

Year Annual Cash Return We already recovered Php 90,000.00 by

1 Php25,000.00
2 Php30,000.00
3 Php35,000.00
4 Php40,000.00
5 Php45,000.00
adding the cash returns in year 1, 2 and 3. We
Php90,000.00 only need Php 10,000.00 to reach the initial
investment of Php100,000.00. So in Year 4,
we only need Php 10,000.00 from the Php
40,000.00 projected cash return, which is 0.25
or 25% of the annual cash return.

The payback period is 3.25 years (3 + 0.25).

2. Net Present Value (NPV)

This refers to the difference between the present value of cash inflows and the net present value of cash
outflows over a period. It is used in capital budgeting and investment planning to analyze if the project is
profitable or not. I
f the NPV is positive, the project or investment should be accepted. If it is negative, it means that it will
result to a loss so it should be rejected.
Example 3: ABCD Company is considering which project it should accept. Project A requires an initial investment of Php
120,000.00 and expects to realize an annual cash return of Php 25,000.00 for 6 years. Project B requires an initial
investment of Php 130,000.00 and the expected annual cash return is Php 28,000.00 for 6 years. Compute for the NPV of
both projects if the cost of capital is 7%.

Project A Project B You can use the

Php 25,000.00 Php 28,000.00 PVIFA table in page 9.
x PVIFA (4.766540) x PVIFA (4.766540) Locate 6 years at 7%.
Php 119,163.50 Php 133,463.12
Less: Php 120,000.00 Less: Php 130,000.00
(Php 836.50) Php 3, 463.12

Project A has a negative NPV while Project B has positive NPV. Project B should be accepted.

Another formula can be used in computing the net present value (even or uneven cash returns.) Let us use Project A as an
example.

Present Value
Cash Returns Cash Returns
= Initial Investment + 1 + 2 + …..
(1+r ) (1+r )
Php 25,000.00 Php 25,000.00 Php 25,000.00 Php 25,000.00 Php 25,000.00
= 1 + 2 + 3 + 4 + 5 +
(1+.07) (1+.07) (1+.07) (1+.07) (1+.07)
Php 25,000.00
6
(1+.07)
= -Php 120, 000.00 + Php 23, 364.49 + 21, 835.97 + 20, 407.45 + 19, 072.38 + 17, 824.65 + 16, 658. 56
= Php 120, 000.00 – Php 119,163.50
= (Php 836.50)
 BUSINESS FINANCE 33

3. Internal Rate of Return (IRR)

The IRR is the most used technique in capital budgeting. It is defined as the discount rate that makes the net present
value of an investment equals to zero.

Example 4: ABCD Company is evaluating the profitability of Project A. It requires Php 100,000.00 of funding and after
one year, the company is expected to receive Php 125,000.00. Compute for the internal rate of return.

IRR = Php 25,000.00/Php 100,000. 00 = .25 or 25%

NPV = Php 125, 000/(1+.25) – Php 100,000.00 = 0