Introduction to Financial

Institutions and Markets

Accountancy, Business and Management
Financing
- to determine the appropriate
capital structure of the
company and to raise funds
from debt and equity.
Accounting Equation

Assets = Liabilities + Owner’s Equity

 Capital Structure
- refers to how much of your total
assets is financed by:

 equity – money from owners pockets

 debt - money from borrowings

Types of Investments
 Short term investment decisions are needed
when the company is in an excess cash
position.

• To plan for this, the Financial Manager should be

able to make use of Financial Planning tools such as
budgeting and forecasting which will be discussed in
Lesson 3

• Moreover, the company should choose which type of

investment it should invest in that would provide an
most optimal risk and return trade off.
Types of Investments
 Long term investments - should be
supported by a capital budgeting analysis
which is among the responsibilities of a
finance manager.

• Capital budgeting analysis is a tool to

assess whether the investment will be
profitable in the long run. This is crucial
function of the management especially if this
investment would be financed by debt
 Operating Decisions
Q1: Why does a Financial Manager need to choose
which source of financing a company should use?

Q2: What do they need to consider in making this

decision?

-
Operating Decisions
a.) Short Term sources - are those that will be payable in
at most 12 months. This includes short-term loans with banks and
suppliers’ credit.

a.1 For short-term bank loans - the interest rate is generally lower
as compared to that of long-term loans. Hence, this would lead to a
lower financing cost.

a.2 Suppliers’ credit - are the amounts owed to suppliers for the
inventories they delivered or services they provided. While suppliers’
credit is generally free of interest charges, the obligations with them
have to be paid on time to maintain good supplier relationship. Such
relationships should be nurtured to ensure timely delivery of
inventories. -
Operating Decisions
Note:

Short term sources - pose a trade-off

profitability and liquidity risk. Because this
source matures in a short period, there is a
possibility that the company may not be able
to obtain enough cash to pay their obligation
Operating Decisions
Long term sources
b. - mature in longer periods.
Since this will be paid much later, the lenders expect
more risk and place a higher interest rate which makes
the cost of long term sources higher than short term
sources.

However, since long term sources have a longer time to

mature, it gives the company more time to accumulate
cash to pay off the obligation in the future.

Hence, the choice between short and long term sources

depends on the risk and return trade off that
management is willing to take.
 Dividend Policies
- These determine when the company should declare
cash dividends. Dividends can only be declared if there
are excess funds.
- it is the role of a financial manager to determine
when the company should declare cash
Note:
Before a company may be able to declare cash dividends,
two conditions must exist:

1. The company must have enough retained earnings

(accumulated profits) to support cash dividend
declaration.
2. The company must have cash.
Types of Liquidity Risk
A. Risk that the company will fail to pay its short term
obligations.

A. Risk that you will not be able to sell investments in

financial assets immediately.
-
Investing function vs Dividend policies
Recall that one of the functions of a finance manager
is investing and its available cash may be used to
invest in long term investments that would increase
the profitability of the company.

Some small enterprises which are undergoing

expansion may have limited access to long term
financing (both long term debt and equity). This
results to these small companies reinvesting their
earnings into their business rather than paying them
out as dividends.
 Investing function vs Dividend policies
 On the other hand, a company which has access to long term
sources of funds may be able to declare dividends even if they are
faced with investment opportunities. However these investment
opportunities are generally financed by both debt and equity.

 The management usually appropriates a portion of retained

earnings for investment undertakings and this may limit the amount
of retained earnings available for dividend declaration.

 Creditors are not willing to finance entirely the cost of a company’s

long term investment. Hence, the need for equity financing (e.g.
internally generated funds or issuance of new shares)

Examples of these companies are publicly listed companies such as

PLDT, Globe Telecom, and Petron. PLDT and Globe are two of the
Philippine listed companies which have generously distributed cash
dividends for the last five years (information as of 2014).
Investing function vs Dividend policies
For companies which have limited access to
capital and have target capital structure, they
may end up with a residual dividend policy.
This means that when companies are faced
with investment opportunities, internally
generated funds will be used first to finance
these investments and dividends can only be
declared if there are excess funds.
What is the financial system
concerned with?
Money
Credit
Services
finance
 Functions of Financial system

FinancialInstitutions- act as mobilisers

and depositories of saving and as the
custodian of finance.

Provides various financial services to the

society.
Financial institution
A financial institution is an institution whose
primary source of profits is through financial
asset transactions

Financial Assets:
-cash
-an equity instrument of another entity
-A contractual right to exchange instruments
with another entity under conditions that are
potentially favorable.
e.g. notes receivable, loans receivable,
investment in stocks, investments in bonds
Classifications of Financial
Institutions
Banks
Stock Brokerage Firms
Non Banking Financial Institutions
Building Societies
Asset Management Firms
Credit Unions
Insurance Companies
 Functions of Financial
Institutions
The principal function of financial
institutions is to collect funds from
the investors and direct the funds to
various financial services providers in
search for those funds.
Financial Markets
A financial market is a market in
which financial assets are traded. In
addition to enabling exchange of
previously issued financial assets
Six basic functions of financial
markets
Borrowing and Lending
Price Determination
Information Aggregation and
Coordination
Risk Sharing
Liquidity
Efficiency
 Financial instruments are cash,
evidence of an ownership interest in
an entity, or a contractual right to
receive, or deliver, cash or another
financial instrument.

Financial Instruments
Categorization of Financial
Instruments
 Cash instruments :are financial
instruments whose value is determined
directly by markets. They can be divided
into securities, which are readily
transferable, and other cash instruments
such as loans and deposits, where both
borrower and lender have to agree on a
transfer
 Derivatives instruments: are financial
contracts, or financial instruments, whose
prices are derived from the price of
something else
 Equilibrium in financial Markets
When the expected demand for funds
matches with the planned supply of
funds generated out of saving and
credit creation or when the total
desired borrowing is equal to the total
desired lending.
Determinants of supply of funds
Aggregate savings by the household
sector
Aggregate savings by the business
sector
Aggregate savings by the government
 Determinants of demand
for funds
Investment in fixed and circulating
capital (working capital)
Demand for consumer durables
Investment for housing