Introduction To Financial Management

I. Introduction to finance
DEFINITION
Finance art and science of managing money
At the personal level, finance is concerned with individuals decisions about how much of their
earnings they spend, how much they save, and how they invest their savings.
In a business context, finance involves the same types of decisions:
how firms raise money from investors
how firms invest money in an attempt to earn a profit
how they decide whether to reinvest profits in the business or distribute them back to
investors.

GOAL
Goal of Finance - maximize the wealth of the owners (shareholders) for whom it is being operated,
or equivalently, to maximize the stock price.
Goal of Profit maximization - too simplistic in that it assumes away the problems of uncertainty of
returns and the timing of returns.
Rather than use this goal, we have chosen maximization of shareholders' wealththat is,
maximization of the market value of the firm's common stockbecause the effects of all financial
decisions are included. The shareholders react to poor investment or dividend decisions by causing
the total value of the firm's stock to fall and react to good decisions by pushing the price of the stock
upward. In this way, all financial decisions are evaluated, and all financial decisions affect shareholder
wealth.
The goal of shareholder wealth maximization must be looked at as a long-run goal. As such, the
public image of the firm may be of concern inasmuch as it may affect sales and legislation. Thus,
while these actions may not directly result in increased profits, they may affect consumers' and
legislators' attitudes.
Although that goal sounds simple, implementing it is not always easy. To determine whether a particular
course of action will increase or decrease a firms share price, managers have to:
(1) assess what return (that is, cash inflows net of cash outflows) the action will bring and how risky
that return might be; and indirectly

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

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

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

3. Management Strategic thinking, job performance, profitability

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

II. LEGAL FORMS OF ORGANIZATION

A. Sole Proprietorship A sole proprietorship is a business owned by one person who operates it for
his or her own profit. The typical sole proprietorship is small, such as a sari-sari store, convenience
store, barbershop, parlor, and hardware shop.

ADVANTAGES DISADVANTAGES

Owner receives all profits. Owner has unlimited liability total wealth can
be taken to satisfy debts

Low organizational cost Limited fund-raising power tends to inhibit

growth

Income is included and taxed on proprietors Proprietor must be jack-of-all-trades

personal tax return

Independence Difficult to give employees long-run career

opportunities

Secrecy Loses continuity when proprietor (owner) dies

Ease of dissolution

B. Partnership A partnership formed through a contract whereby two or more persons bind
themselves to contribute money, property, or industry into a common fund with the intention of
dividing profits among themselves. (Art. 1767, Civil Code of the Philippines)

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

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

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

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

5. Legal entity. A partnership has a legal personality separate and distinct from that of each of the
partners.

6. Income tax. Partnerships, except general professional partnerships (i.e. those organized for the
exercise of profession like CPAs, lawyers, engineers, etc.) are subject to 30% income tax.

ADVANTAGES DISADVANTAGES

It is easy and inexpensive to organize, as it is
formed by a simple contract between two or
more persons.
The unlimited liability of the partners makes it
reliable from the point of view of creditors.
The combined personal credit of the partners
offers better opportunity for obtaining additional
capital than does a sole proprietorship.
The participation in the business by more than
one person makes it possible for a closer
supervision of all the partnership activities.
The personal liability of a partner for firm debts
deters many from investing capital in a
partnership.
A partner may be subject to personal liability for
the wrongful acts or omission of his/her
associates.
It is less stable because it can easily be dissolved.
There is divided authority among the partners.
 The direct gain to the partners is an incentive to There is constant likelihood of dissension and
give close attention to the business disagreement when each of the partners has the
same authority in the management of the firm.

The personal element in the characters of the

partners is retained.

C. Corporation a corporation is an artificial being created by operation of law, having the right of
succession and the powers, attributes and properties expressly authorized by law or incident to its
existence. (Sec. 1, Corporation Code of the Philippines)

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

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

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

(4) Powers, attributed, properties authorized by law. A corporation has only the powers, attributes and
properties expressly authorized by law or incident to its existence. Being a mere creation of law, a
corporation can only exercise powers provided by law and those powers which are incidental to its
existence.

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

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

ADVANTAGES DISADVANTAGES

The corporation enjoys a continuous existence It is not easy to organize because of its
because of its power of succession. complicated legal requirements and high costs in
its organization.
The corporation has the ability to obtain a strong The limited liability of its shareholders may
credit line because of continuity of existence. weaken its credit capacity.

Large scale business undertakings are made It is subject to rigid governmental control.
possible because many individuals can invest their
funds in the enterprise.
The liability of its investors or shareholders is It is subject to more taxes.
limited to the extent of their investment in the
corporation.
The transfer of shares can take effect without the Its centralized management restricts a more
need of prior consent of other shareholders. active participation by shareholders in the conduct
of its corporate affairs.
 Its smooth operation is guaranteed because of its
centralized management.

iii. CASH FLOW CYCLE IN AN ORGANIZATION

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

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

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

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

IV. DIFFERENT INDIVIDUALS INVOLVED IN THE FINANCE FUNCTION OF THE

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

1. Vice president for finance/Chief financial officer (CFO) - serves under the firms chief executive officer
(CEO) and is responsible for overseeing financial planning, strategic planning, and controlling the
firms cash flow. Typically, a treasurer and controller serve under the CFO.

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

3. Controller - is responsible for managing the firms accounting duties, including producing financial
statements, cost accounting, paying taxes, and gathering and monitoring the data necessary to
oversee the firms financial well-being.

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

Role of a Financial Manager

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

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

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

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

V. FINANCIAL INSTITUTIONS, INSTRUMENTS AND MARKETS

Financial Institution is an intermediary that channels the savings of individuals, businesses, and
governments into loans or investments.
1. Banks Banks provide mechanism where savers can put their excess funds through deposits. Banks
give the depositors interest on the money deposited to them. To cover/compensate the interest given
to depositors, banks either lend the money to borrowers (with a corresponding interest and after
qualifying from a credit investigation) or invest them on some financial instruments such as
government securities and corporate bonds.

2. Credit unions Credit unions are cooperative associations whose members have a common bond,
such as being employees of the same firm or living in the same geographic area. Members savings
are loaned only to other members, generally for auto purchases, home improvement loans, and home
mortgages. Credit unions are often the cheapest source of funds available to individual borrowers.

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

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

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

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

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

b. Preference Share Capital (Preferred Stocks) it entitles the holder to enjoy priority as to
distribution of dividends and distribution of assets upon corporate liquidation.
 2. Debt Securities these are instruments representing a creditor relationship with an enterprise. These
are the following characteristics of debt securities: (1) maturity value, periodic interest payments at
a fixed or variable interest rate, and (3) maturity date. This type of securities may take in the form
of bills, notes, bonds, commercial papers, or promissory notes.

a. Treasury Bills - Treasury Bills are government securities issued by the Bureau of the Treasury
(BOTr) which mature in less than a year. There are three tenors of Treasury Bills: (1) 91 day (2)
182-day (3) 364-day Bills. The number of days is based on the universal practice around the world
of ensuring that the bills mature on a business day.

b. Treasury Bonds Treasury Bonds are government securities issued by the Bureau of the Treasury
(BOTr) which mature beyond one year. At present there are five maturities of bonds (1) 2- year
(2) 5 year (3) 7 year 4) 10 year and (5) 20-year. These are sold at its face value on
origination.

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

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

(3) Primary vs. Secondary

Primary markets are the markets in which corporations raise new capital. If Microsoft were to sell a
new issue of common stock to raise capital, this would be a primary market transaction. The
corporation selling the newly created stock receives the proceeds from such a transaction.
Secondary markets are markets in which existing, already outstanding securities are traded among
investors.
(4) Spot vs. Futures
Spot markets and futures markets are markets where assets are being bought or sold for on-the-
spot delivery (literally, within a few days) or for delivery at some future date, such as 6 months or
a year into the future.

(5) Public vs. Private

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

VI. FINANCIAL MANAGEMENT FRAMEWORK

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

This depicts the general flow of funds through and between financial institutions and financial markets
as well as the mechanics of private placement transactions. Domestic or foreign individuals, businesses, and
governments may supply and demand funds.
Flow and Circulation of Funds and Financial Instruments (Securities) in the Over-all Economy (Segmented Version)

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

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

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