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BUSINESS FINANCE READING MATERIALS

BUSINESS FINANCE OVERVIEW

As a child, you probably looked to your parents for allowance, to borrow money or to help you
save up for that shiny new bicycle. Your parents were the financial core of your household.
Companies also have a financial hub of their own: business finance.

Definition
Business Finance is essentially the wallet of an organization. A company's finance department
monitors spending, tracks purchases, develops financial strategies, analyses cash statements and
researches investments.

Features
Business Finance Departments are comprised of financial analysts, accountants, budget
specialists and finance directors. Chief Financial Officers (CFOs) oversee business finance
operations.

Significance
A company's finance department keeps the business' finances in order and on track. Business
finance helps companies achieve their financial goals.

Function
Finance employees must juggle a lot of information. Cash flow statements, budgets and balance
sheets are just a few of the many reports and statements that need analyzing. Finance employees
must also keep up with bank loans, investments, investors, stocks and shares, and the capital
structure.

Effects
Business Finance shapes the direction of companies and provides guidance for financial
decisions. It has a great influence over how companies do business.

What Are the Functions of Business Finance?

Business Finance is the sector of business that supports the many departments and projects that
are necessary for a functioning business model. The functions of business finance that are most
important revolve around accounting, planning and record keeping. In order for businesses to
have a strong financial anchoring, they must be fully aware of the financial resources they have
available for various projects and necessities. Along with financial planning, business finance
departments are also charged with supplying government auditors with accurate data and reports
for the various financial audits that are required of public companies.

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THE NATURE AND AIMS OF BUSINESS

Businesses thrive in an environment that is conducive to growth and expansion. Although the
Philippine economy is saddled with difficulties, business firms still find ways to achieve their
objectives.

Business firms in a free enterprise system take the lead role in the attainment of the countrys
economic targets. Firms which are often in competition with one another, bring into the market a
wide array of products and services.

THE PHILIPPINE ECONOMY

SERIOUS CONCERNS AFFECTING PHILIPPINE ECONOMIC DEVELOPMENT


1. Low Productivity in the workplace
2. Graft and Corruption in the government
3. Declining value of peso
4. Unfavorable balance of trade

FACTORS THAT CONTRIBUTE TO BUSINESS SUCCESS


1. Economic Growth
2. Availability of Capital
3. Proper Management
4. Resource Allocation Skill (Financial Managerial Ability)

ROLE OF BUSINESS TO THE ECONOMY


1. To provide goods and services to the society
2. To increase the living standard of people through bringing wide array of goods and
services to the market

BUSINESS - is any lawful economic activity concerned with the production and/or distribution
of goods or services for profit.

THREE KINDS OF BUSINESS:


1. COMMERCE trading; buying and selling; merchandising; marketing
2. INDUSTRY A. Genetic Industries agriculture, forestry; fish culture; B. Extractive
Industries mining, lumbering, fishing, hunting C. Manufacturing Industries drugs
manufacturing; plastic manufacturing; liquor manufacturing D. Construction Industries
building infrastructures like airport; seaports and highways
3. SERVICES - A. Recreation movie houses; television and radio stations; theaters for
drama; stage presentation; B. Personal restaurants; barber shops; transportations; hotels
C. Finance banks; insurance companies; investment houses; financing institutions

OBJECTIVES OF BUSINESS
Business is for profit but other goals are also considered such as:
1. Political Influence
2. Family Control of the Business

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3. Community Involvement

MULTIPLE OBJECTIVES OF BUSINESS FIRMS:


1. The protection and enhancement of the human and physical resources of society
2. Economy and effectiveness of operation
3. The provision of products and services to the community
4. The satisfaction of personal objective

ORGANIZING A BUSINESS- is the first stage and important aspect in the life cycle of the
business.

THE IMPORTANCE OF ORGANIZATIONAL STAGE IN BUSINESS LIFE CYCLE


1. A business organization like corporation, undertakes complicated activities, which are
impossible to be accomplished without this stage.
2. Business failures have become common occurrences because of defects in planning at the
organizational stage.

VALUES DERIVED FROM ENGAGING IN A BUSINESS.


Persons engage in business to enjoy certain values which are:
1. Provision of employment to people
2. Profit
3. Service to the community
4. Personal satisfaction
5. Means to earn a living
6. Achievement of power
7. Protection of ones self and family

ENTREPRENEURSHIP
To engage in business, the options are:
1. To buy an existing business
2. To create a new business

ENTREPRENEURSHIP refers to the ability to take the risk of gaining profit or incurring
losses from the business he/she established.

ENTREPRENEUR refers to a person who chooses to create a business that he will operate.

THE FUNCTION OF THE ENTREPRENEURS


1. To supply the capital of the firm;
2. To organize production by buying and combining inputs;
3. To decide on the rate of output in the light of his expectations about demand and
4. To bear the risk involved in these activities.

BUSINESS PROSPECTING
In business prospecting, one must engage in a search for business opportunities.

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WAYS TO CONSIDER IN DETERMINING A BUSINESS PROSPECT:
1. He should carefully scan the environment for other possible opening.
2. He should prepare a list of alternative business opportunities.
3. He should make his choice from that list.

THE SEARCH FOR BUSINESS OPPORTUNITIES


1. A person searching for a suitable business opportunity should learn the ways of a talent
scout or a salesman looking for a prospect.
2. Like a talent scout, the prospective businessman should have the skill to choose an
opening that will be commercial and will bring him enough revenues.
3. Like a salesman, the prospective investor should have the skill to pick the right business
opportunity from his list and which is of better quality than the others indicated in the
same list.

BUSINESS PROMOTION - is discovering and exploring a business opportunity with the


purpose of converting it into a going concern.

3 STEPS INVOLVED IN BUSINESS PROMOTION


1. Discovering the idea for new business
2. Determining the feasibility of the idea
3. Assembling the needed resources to start the business

DISCOVERY refers to the identification for a new business is the first step in business
promotion.
DETERMINATION OF FEASIBILITY once a choice has been made on the business idea to
adapt, its feasibility should be determined. Oftentimes, a feasibility studies is required.

FEASIBILITY STUDY is a detailed investigation and analysis of a proposed business venture


to determine its viability.
CONTENT OF THE FEASIBILITY STUDY- according to the need, the study must contain
some or all of the following aspects:
1. Management Study
2. Marketing Study
3. Technical Study (Production Facilities And The Product)
4. Taxation And Legal Aspects
5. Financing Aspects
6. Profitability
7. Social Desirability

ASSEMBLING THE NEEDED RESOURCES - once the feasibility of a proposed business


project is determined by expert, the proponent may proceed to assemble the needed resources.
This is made prior to the start of business operation. The resources needed may comprise of the
following:
1. Initial Capital Requirements
2. Sources of Initial Capital
3. Retention of Control

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4. Valuation

PROMOTER-is the person responsible for the formulation of a company.

CLASSIFICATION OF PROMOTER:
Promoter may be classified as follow:
1. Professional Promoters responsible for business promotion
2. Side-line Promoters occasionally perform promotion activities
3. Banking Promoters banking institutions which provide business promotion services
4. Financial Promoters consist of investment houses engaged in the promotion of certain
business ventures through the sale of securities
5. Subdivision Promoters engaged in the development of new subdivisions

FUNDAMENTAL CONCEPTS AND TOOLS OF BUSINESS FINANCE

FINANCE- refers to the study of the acquisition and investment of cash for the purpose of
enhancing value and wealth.

CATEGORIES OF FINANCE
Finance may be categorized as:
PUBLIC FINANCE general finance, which deals with the revenue and expenditure patterns
of the government and there various effects on economy.
PRIVATE FINANCE this deals with the area of general finance not classified under public
finance.

PRIVATE FINANCE SUB DIVIDED INTO:


1. Personal Finance is concerned with the fundamentals of managing ones own personal
money affairs.
2. The Finance of Non-Profit Organizations includes private undertakings such as
charity, religion and some private educational institutions.
3. Business Finance refers to the provision of money for commercial use, as well as the
effective use of funds.

THREE ASPECTS CONCERNING BUSINESS FINANCE


1. Small Business Finance
2. Corporation Finance
3. Multinational Business Finance

VARIOUS GOALS OF BUSINESS FINANCE


1. Maximizing Profits
2. Maximizing Profitability
3. Maximizing Profit Subject to Cash Constraint
4. Maximizing Net Present Worth
5. Seeking an Optimum Position Along a Risk-return Frontier

MAXIMIZING PROFIT realizing the highest possible peso or dollar income

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MAXIMIZING PROFITABILITY occurs when a firm decides on obtaining a higher rate of
return on its investment.

MAXIMIZING NET PRESENT WORTH the firms objective is to maximize the current
value of the company to its owners.
-The Net Present Worth of the firm is equal to the value now of the firm plus values
arising in the future.
-The present worth of values arising in the future are computed and added to the present
worth of the other values of the firm.

TIME VALUE OF MONEY indicates that money increases in value with the passing of time.
-A peso today could be deposited in a bank and made to earn interest. This capacity to
earn makes the peso today worth more than the peso that would be received in the future.
-To be able to find out the present worth of a peso that would be received in the future,
the corresponding interest (or discount) should be deducted from the future peso.

SEEKING AN OPTIMUM POSITION ALONG A RISK-RETURN FRONTIER implies


that a firm can set goal of achieving the best combination of risk and return.

RETURN ON INVESTMENT OR NET WORTH refers to the net income generated by the
use of investments of a firm.
RATE OF RETURN return on investment expressed in percentage.
RISK potential incurrence of loss of money or its equivalent due to uncertainty.
FINANCIAL STATEMENTS - are those that present financial information to various
interested parties.
FINANCIAL MANAGER one of the most concerned about getting relevant information
through the use of financial statements.

TWO TYPES OF FINANCIAL STATEMENT CONSIDERED IMPORTANT IN


BUSINESS FINANCE

BALANCE SHEET the statement produced periodically, showing an organizations assets,


liabilities and interest of the owners.
INCOME STATEMENT represents the revenues realized from the sale of commodities and
services produced by the company; and the cost and expenses incurred in connection with the
realization of said revenues.

THE BUDGET
Concerning the finance function of the manager, one of the useful tools he could use is the
budget.

BUDGET Is defined as an estimate of income and expenditures for a future period. Budgets are
essential elements in the planning and control of the financial affairs of the business.

SALES BUDGET is the starting point of companys budgets. It shows an estimate of in sales
units and dollars or pesos for major subdivision of sales.

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THE MATERIALS AND PURCHASES BUDGET this portion of the company budget
refers to the estimate of the materials required by the firm, specified in quantities, costs, timing
of purchase, the required delivery dates and other requirements.

THE PRODUCTION BUDGET is an estimate of the quantity of products that should be


produced in accordance with the sales budget.

SIGNIFICANCE OF FINANCIAL STATEMENTS AND BUDGETS


Financial statement and budgets of the firm are the concern of:
The Owners
The Management
The Creditors
The Government
Prospective Investors

Budgets are especially important to management because they are able to do the following:
1. Anticipate asset needs
2. Plan for necessary financing
3. Establish standards by which to test current operating performance.

THE ANNUAL REPORT


The report send out each year by the company to its stockholders or members is called the
annual report. It normally contains the following:
1. The Balance Sheet
2. The Profit and Loss Statement
3. The Auditors Report
4. The Chairmans Report
In case the firm is part of a group, the report must also contain a consolidated balance sheet and
consolidated profit and loss statement.

BASIC CONCEPTS OF FINANCIAL MARKETS

The financial success of any business firm will depend much on the quality of decisions made by
management regarding the firms financial activities. An important requirement is the clear
understanding of financial markets and how they operate.

FINANCIAL MARKETS perform a vital role in the operation of the overall financial system
including business finance.
- Refer to the context where the suppliers and the users of funds meet.
- Individual and firms with surplus funds invest or lend funds in the financial market.
- Individual and firms with the need for funds borrow money in the financial market.

BENEFITS OF FINANCIAL MARKETS


1. Funds are directed to DSUs which can use them most efficiently
- Deficit Spending Units (DSUs) that can use borrowed funds in the most productive
manner can afford to pay higher interest rates.

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- The competition among DSUs for the use of the funds made available by the financial
market will push interest rates higher, which motivate savers or Surplus Spending
Units (SSUs) to save more so they will have more funds for lending.

2. Liquidity is provided to savers


- Without the intervention of financial markets, savers will directly lend to borrowers,
forcing the lender to wait for the maturity date of the loan before he gets his money
back.
- The lender will be at a disadvantage if he finds out later that he need the loaned
amount before maturity.
- This problem is eliminated when the financial markets are tapped.

WHY FIRMS INVEST AND BORROW


- Firms are confronted by capital deficiency.
- Owners of the firm cannot provide additional capital so they resort to borrowing.

METHOD BY WHICH FINANCIAL MARKETS TRANSFER FUNDS

When firms need funds, the financial markets provide two methods by which funds could be
transferred to them. The methods consist of Direct and Indirect Finance.

DIRECT FINANCE- refers to lending by ultimate borrowers with no intermediary.


- Provides SSUs with a venue for savings with expected returns and DSUs with a source of funds
for consumption or investments.
-It increases the efficiency of the financial market.

DIRECT FINANCING (DISADVANTAGES)


-There are few DSUs which can transact in the direct market because the denominations of
securities sold are very large.
-It is difficult to match the requirements of SSUs and DSUs in terms of denomination, maturity
and other factors.
METHODS OF DIRECT FINANCING

1. Private Placements- refer to the selling of securities by private negotiation directly to


insurance companies, commercial banks, pension funds, large-scale corporate investors,
and wealthy individual.
2. Broker and Dealer- Broker is one who acts as an intermediary between buyers and
sellers but not take title to the securities traded. Dealer- is one who is in the security
business acting as a principal rather than agent.
3. Investment Banker - is a person who provides financial advice and who underwrites and
distributes new investment securities.
INDIRECT FINANCE-(also called financial intermediation) refers to lending by an ultimate
lender to a financial intermediary that then relends to ultimate borrowers. Financial

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intermediaries include commercial banks, mutual savings, credit unions, life insurance
companies, and pension funds.

CLASSIFICATION OF FINANCIAL MARKETS

1. Primary Market - a financial market in which newly issued primary and secondary
securities are traded for the first time.
2. Secondary Market - is that financial market through which existing securities are
traded.
3. Money Market -is that financial market on which debt securities with an original
maturity of one year or less are traded.
4. Capital Market - is that portion of the financial market where trading is undertaken
for securities with maturity of more than one year.
5. Bond Market - the market for debt instruments of any kind.
6. Stock Market - is that financial market where the common and preferred stocks
issued by corporation are traded. Two Components: a) The organized exchanges and
b) The less formal over the-counter markets. In the Philippines, the stocks are
openly traded in the Philippines Stock Exchange.
7. Mortgage Market - is that portion of the financial market which deals with loans on
residential, commercial, and industrial real estate, and on farmland.
8. Consumer Credit Market-the market involved in loans on autos, appliances,
education, and travel is referred to as the consumer credit market.
9. Auction Market - is one where trading is conducted by an independent third party
according to a matching of prices on orders received to buy and sell a particular
security.
10. Negotiation Market- when buyers and sellers of securities negotiate with each other
regarding price and volume, either directly or through a broker or dealer.
11. Organized Market- is that financial market with fixed trading rules.
12. Over-the-Counter Market- is that market consisting of large collection of brokers
and dealers, connected electronically by telephones and computers that provide for
trading in unlisted securities.
13. Spot Market- when securities are traded for immediate delivery and payment, the
market type referred to is the spot market. The Spot Price is the price paid for security
that will be delivered on the spot immediately.
14. Futures Markets is that market where contracts are originated and traded that
gives the holder the right to buy something in the future at a price specified by the
contract.
15. Options Market-is one where stock options are traded. A stock option is a contact
giving the owner the right to either buy or sell a fixed number of shares of a stock
(usually 100) at any time before the expiration date at a price specified in the portion.
16. Foreign Exchange Market- is the market where people buy and sell foreign
currencies.

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CAPITAL BUDGETING

CAPITAL BUDGETING -is an important segment of business finance. It includes relevant


aspects of investment, valuation, risk and uncertainty.

For a better understanding of capital budgeting concepts, the following terms are defined and
explained:

CAPITAL EXPENDITURES refers to substantial outlay of funds for the purpose of lowering
costs and increasing net income for several years in the future.

CLASSES OF CAPITAL EXPENDITURES:


1. Replacement Investments refers to investments on replacement of worn-out or
obsolete facilities.
2. Expansion Investments this type of expenditure will provide additional facilities to
increase the production and/or distribution capabilities of the firm.
3. Product-Line or New Market Investments this refers to expenditures on new
products or new markets, and on improvement of old products with the combined
features of replacement and expansion investments.
4. Investment in Safety and/or Environmental Projects these are expenditures
necessary to comply with government orders, labor agreements, or insurance policy
terms. These are sometimes called mandatory investment or non-revenue producing
projects.
5. Strategic Investments these are projects designed to accomplish the overall objectives
of the firm.
6. Other Investments this catch-all term includes office buildings, parking lots, executive
aircraft.

CAPITAL BUDGETING refers to the planning and control of capital expenditures.

VALUATION- the process of evaluating the proposals real worth for capital expenditure to the
firm.

An INVESTMENT happens when the firm spends some of its funds for the establishment of a
project. It is also the opportunity to use the same funds in other possible project is lost.

OBJECTIVES OF CAPITAL BUDGETING:


1. Establishing Priorities the resources of the firm is said to be limited. The total
number of opportunities available for investment cannot all be accommodated by the
firm. Capital budgeting will help to solve this difficulty. This is possible because
investment priorities are established in capital budgeting.
2. Cash Planning the objective of cash planning activities of the firm is to ensure the
availability of funds that will be sufficient to meet its cash requirements, including those
concerning the acquisition of capital assets. A periodic cash expenditures estimate
included in the capital budget helps to attain such objective.

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3. Construction Planning - the objective of construction planning is to minimize the period
expended for the construction or acquisition of a capital asset. The construction plan, a
requirement for capital budgeting, will be presented before the capital budget is prepared.
This requirement ensures the preparation of such plans.
4. Eliminating Duplication a centralized capital activity will help identify efforts
undertaken at various levels in a decentralized organization. The duplication of efforts,
as a result, will be minimized if not totally eliminated.
5. Revising Plans changes in the environmental factors may require appropriate revisions
in the authorization of investment projects which include expected profitability,
construction cost, and the timing of start-up, where coordination with related activities is
essential.

Capital Budgeting System Consists of the Following Steps:


1. Preparation and submission of budget requests
2. Approval of budget
3. Request for appropriation
4. Submission of progress reports
5. Post approval review

EVALUATION OF PROPOSED CAPITAL EXPENDITURES

PRIMARY FACTORS CONSIDERED IN EVALUATING PROPOSED CAPITAL


EXPENDITURES ARE:
1. Urgency decisions should be made as quickly as possible for requirements that are
urgent.
2. Repairs Management should consider the availability of spare parts and
maintenance experts.
3. Credit this factor should be considered in the sense that some credit terms may be
highly favorable to the company.
4. Non-Economic Factors these refer to social considerations, and other non-
economic persuasions and preferences.
5. Investment Worth this refers to the economic evaluation of a certain proposal.
6. Risk Involved this refers to the uncertainty of an expected return.

METHODS OF ECONOMIC EVALUATION


The economic evaluation of proposals consists of three basic methods:
1. The Payback Method determines the number of years required to recover the cash
investment made on a project. The recovery of cash comes from the cash inflows generated
from the project. The formula used is as follows:

Payback Period = ______Cost_____


Annual Cash Flow

2. THE AVERAGE RATE OF RETURN METHOD consists of the following: 1) the


average return on investment and 2) the average return on average investment.

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Average Return On Investment - this method is simple and is easy to compute. It shows
the ratio of the average cash inflow to the investment. The formula is as follows:

Average Return On Investment = Annual Cash Flow_


Investment Outlay

Average Return On Average Investment This method is similar to the average return on
investment method except that the effect of the depreciation charge on the investment is
taken into consideration.

Average return on average investment = Annual Cash Flow_


Investment/2

The main disadvantage of average return on investment and average return on average
investment, time value of money does not take into account.

3. The Discounted Cash Flow Methods the time value of money is recognized under the
discounted cash flow methods. There are two approaches available 1) the net present
value method and 2) the internal rate of return method. Under these approaches, all
future values of a proposal are discounted and compared to the values of other proposals.

Net Present Value Method under this method, a desired rate of return is used for
discounting purposes.

NPV = PVCI PVCO


Where NPV = Net present value
PVCI = discounted value of the anticipated cash inflows
PVCO = discounted value of the anticipated cash outflows

The formula for finding the present value of an expected cash inflow is as follows:
PV = ______A_______
(1 + R)n
Where A= expected cash inflow
R= desired rate of return
n = number of years the cash inflow is expected

SAMPLE COMPUTATION
A Sample Investment Proposal for the Purchase of a Machine

Acquisition Cost 10,000,000.00


Economic Life 10 years
Salvage Value 100,000.00
Earnings and Cost per year
Income 5,000,000.00
Expenses -2,000,000.00
Net Income before tax and depreciation 3,000,000.00

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Less : Depreciation (straight line) -1,000,000.00
Net Income Before Tax 2,000,000.00
Less : Income Tax -620,000.00
Average Net Annual Earnings 1,380,000.00

Cash Inflow Per Year = Net Earnings + Depreciation


= (1,380,000 + 1,000,000 ) =P 2,380,000.00

Payback Period Method = 10,000,000/2,380,000 = 4.2 years

Average Return on Investment = 2,380,000/10,000,000 = 24%

Average Return on Average Investment = 2,380,000/(10,000,000/2) = 48%

PV of Cash Inflow, Year 2 if desired rate is 25%

PV = 2,380,000/(1 + .25)2 = 2,380,000/(1.25)2* = 1,523,200

*1.25 x 1.25 = 1.5625

MEANING OF RISK, UNCERTAINTY AND SENSITIVITY

RISK the uncertainty concerning loss. (Strict Definition) implies incomplete (more than 0 but
less than 100%) available information about the future outcome.

FACTORS AFFECTING RISK


There are primary factors involved in the evaluation of risks pertaining to capital expenditures:
1. Possible inaccuracy of the figures used in the evaluation
2. Type of business involved.
3. Type of physical plant and equipment involved.
4. The lengths of time that must pass before all the conditions of the evaluation become
fulfilled.

UNCERTAINTY a term used interchangeably with risk. (Strict Definition) implies zero
information about the future outcomes.

SENSITIVITY - refers to the effect of investment of changes in some factors, which were not
previously determined with certainty. Sensitivity analysis is applicable to capital expenditures
involving the purchase of construction of a plant. It is useful for management to know the
expected returns that will be generated

WORKING CAPITAL

WORKING CAPITAL - the portion of the total capital of the firm which finance the day-to-
day activities and it is continually circulating.

GROSS WORKING CAPITAL refers to the firms total current assets.

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NET WORKING CAPITAL is the total amount of current assets minus current liabilities.

WORKING CAPITAL IS NEEDED FOR THE FOLLOWING PURPOSES:


1. Replenishment of inventory
2. Provision for operating expenses
3. Support for credit sales
4. Provision of a safety margin

CASH REQUIREMENTS
The firm needs cash to pay for expenditures that arise from time to time. The amount of cash
needed depends upon the following;
1. The amount of the firms purchases and cash sales
2. Time period for which the firm receives and grants credits
3. Time period from the dates of purchase of raw materials and payment of wages
4. The amount of cash to be used for investment in inventories
5. The amount of cash needed for other purposes such as cash dividends

ACCOUNTS RECEIVABLE REQUIREMENTS


1. The unpaid portion of credit sales
2. The collections of accounts receivable from customers contribute to cash inflow
requirements of the firm.

MANAGEMENT OF WORKING CAPITAL


Working Capital must be:
1. Adequate to cover all current financial requirements
2. Liquid enough to meet current obligations as they fall due
3. Conserved through proper allocation and economical use
4. Used in the attainment of the profit objectives

LIQUIDITY MANAGEMENT

LIQUIDITY refers to the ability of the firm to pay its bills on time or otherwise meet its
current obligation. Activities geared towards achieving the liquidity objectives of the firms are
called liquidity management.

Management must require sufficient amount of funds to cover the cash requirements of the firm.
Cash inflows come from various sources as follows:
1. Cash Sales
2. Collection of Accounts Receivable
3. Loans
4. Sales of Assets
5. Ownership Contribution
6. Advances from Costumers

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FIVE MAJOR APPROACHES IN CASH MANAGEMENT
1. Exploit techniques of money mobilization to reduce operating requirements.
2. Expend major efforts to increase the precision and reliability of cash flow forecasting.
3. Use maximum efforts to define and quantify the liquidity reserve needs of the company.
4. Develop explicit alternative sources of liquidity
5. Search aggressively for more productive uses of surplus money assets.

IMPROVED CASH FLOW FORECASTING


A cash flow forecast with a high degree of precision and reliability provides the firm with
realistic approaches to planning and budgeting. The disadvantages of cash excess and cash
shortages eliminated if not minimized.

ADVANTAGES BROUGHT BY AN IMPROVED CASH FLOW FORECAST:


1. Surplus funds are more fully invested
2. Alternative methods of meeting the outflows can be explored
3. The creation of special reserves for major future outlays will be minimized.

ACCOUNTS RECEIVABLE MANAGEMENT


The objective of account receivable management is to determine the cost and profitability of
credit sales. There is no point in extending credit to customers if this will cause a lowering of the
firms return on investment.

The second objective of account receivable management is the projection of cash flows from
receivables. This will provide an essential input in the preparation of the firms financial plan.

The third objective relates to the direction and control of activities involved in the extension of
credit to customers.

ELEMENT OF THE COST OF CREDIT


1. Bad Debts Cost refers to account receivable uncollected and subsequently written off.
2. Cost of Invested Funds refers to the rate at which the firm could borrow funds to
finance credit sales.
3. Administrative Costs includes clerical and administrative time spent on account
and credit and investigation expenses.

EVALUATION OF CREDIT RISK


1. Capital refers to the financial resources of the credit applicant.
2. Capacity refers to ability of the applicant to operate successfully.
3. Characters refers to reputation for honesty and fair of the applicant.
4. Conditions refers to the environment required for the extension of credit.

INVENTORY MANAGEMENT
Refers to the activity that keeps track of how many of the procured items needed to create a
product or service are on hand, where each items is, and who has responsibility for each items.
Inventory Management consists of two aspects:
1. Liquidity Aspect is usually measured in terms of inventory turnover.

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2. Profitability Aspect is measured in terms of inventory level at a given level of sales
and profit.

A successful inventory management programs main objective is to strike a balance among three
key elements as follows:
1. Customer Service the period between when the order is made and the date of delivery
is very important to the customer. Shorter period are preferred.
2. Inventory Investment (in terms of currency) most tied up in inventory should ideally
be kept to minimum without sacrificing customer service.
3. Profit the level of inventory carried by the company most often affects the profitability
of the company.

Three Major Forms of Inventory


Raw Materials
Work-In-Process
Finished Goods

Raw materials consist of all parts sub-assemblies and components purchased from other firms
but not yet put into manufacturers own production processes. When raw materials and labor is
added into the basic raw materials inputs, they combined and transformed into work-in process
inventories. They become finished goods when they are completed and stock.

METHODS OF ACHIEVING INVENTORY GOALS:


Inventory goals may be achieved by using any of the several devices available. These devices
are the following:
1. The ABC Method classifies inventory into 3 categories:
A As those comprising a large proportion of the inventory value and in which
tight control is applied.
B Comprises those accounting for a substantial part of inventory value and in
which tight control is applied.
C Items are those that account only for a small proportion of the total inventory
value and as a consequence is the least controlled.
2. The Economic Order Quantity (EOQ) is used to determine what quantity to order so
as to minimize total inventory costs. Two major costs involve EOQ method:
Carrying costs ( warehouse storage costs )
Ordering costs ( filling in purchase requisitions )

These two costs tend to offset each other. One reason is that in large quantities allows
volume discounts, but it also higher storage cost. To balance these factors, an economic
order quantity should be determined. The EOQ formula is as follows:
EOQ = the square roots of 2 US/CI
Where: EOQ = Economic Order Quantity
U = annual usage
S = restocking or ordering cost
C = cost per unit
I = annual carrying cost (expressed as percentage of inventory value)

BUSINESS FINANCE READING MATERIALS#1 Page 16


Thus, if annual usage is 1,000 units, restocking cost is 1,000, cost per unit is 50,000,
and annual carrying cost is 10%, EOQ is
EOQ = square root of (2 x 1,000 x 1,000)/(50,000 x 10%)
EOQ = (2,000,000)/(5,000)
EOQ = 400
EOQ = 20
3. Safety Stocks are the part of inventory used to absorb random fluctuations in
purchases, production and sales. When condition are uncertain, safety stocks are needed.
4. Anticipated Stocks refers to that portion of the inventory used for expected seasonal,
cyclical and secular changes in inventory.

SOURCES OF SHORT TERM CAPITAL

The total business finance function is composed of three segments:


1. Short-Term Financing
2. Intermediate Financing
3. Long Term Financing

SHORT TERM FINANCING deals with the demand and supply of short term funds which
may either secure or unsecured.

ADVANTAGES:
1. Easier to Obtain- the risks involved in lending funds varies according to the length of
payment period. Creditors make short-term credits easier to obtain.
2. Often Less Costly- short term credit is often granted by creditors at less cost.
3. Offers Flexibility to the Borrower- after the short-term credit account is settled by the
debtor, he may use the other sources of credits.

THE SUPPLIERS OF SHORT-TERM FUNDS


1. Trade Creditors
2. Commercial Banks
3. Commercial Paper Houses
4. Finance Companies
5. Factors
6. Insurance Companies
7. Company Accruals

TRADE CREDITORS are suppliers that extend credit to a buyer for use in manufacturing,
processing or reselling goods for profit. Credit is usually unsecured and is known as:
1. Trade Credit
2. Commercial Credit
3. Mercantile Credit
4. Accounts Receivable Credit

NATURE OF TRADE CREDIT


1. Credit extended by a firm to another firm

BUSINESS FINANCE READING MATERIALS#1 Page 17


2. Appears in the book of accounts of the creditor as accounts or notes receivables
3. Appears as accounts or notes payable in the book of the debtor.

TRADE CREDIT INSTRUMENT


1. Open Book Credit - constitutes the bulk of trade credit. It is unsecured and it permits the
customer to pay for goods delivered in a special number of days.
2. Trade Acceptance - is a draft drawn by a seller upon a purchaser, payable to the seller as
payee and accepted by the purchaser as evidence that the goods shipped are satisfactory
and the price is due and payable.
3. Promissory Note - unconditional promise in writing made by one person to another,
signed by the maker engaging to pay on demand or at fixed or determinable future time.

COSTS OF TRADE CREDIT-firms which extend trade credit normally provide incentive to
firm which settle their accounts early. The firm that does not avail of the trade discount incurs a
cost related to the trade credit. This cost may be computed as follows:

Annual Cost of Not Taking Discount = discount X 360 days_____________


1-discount no of days credit-discount period

Example: If the credit term is 5/5, net 60 (which means a 5% discount is deducted from invoice
price if settled within 5 days, otherwise the full amount is due in 60 days), the annual cost is
computed as follows:
Annual Cost of not Taking Discount = 0.05 X 360 days____
1-0.05 60 days 5 days

Annual Cost of not Taking Discount = 0.05 X 360 __


.95 55

Annual Cost of Not Taking Discount = 34.4%

COMMERCIAL BANKS - institutions which individuals or firms may tap as source of short
term financing. - Corporations which accept or create deposits subject to withdrawal by check.

FOUR DISTINCTIVE COMPONENTS


1. Commercial Banks
2. Development Banks
3. Saving Banks
4. Rural Banks

CLASSIFICATION OF SHORT TERM LOANS


1. Unsecured (clean loan) - do not require collateral
2. Secured - require collateral for back-up

COMMERCIAL PAPER HOUSES

BUSINESS FINANCE READING MATERIALS#1 Page 18


COMMERCIAL PAPER - generally unsecured which sold through commercial paper dealers
or directly to investor and issued by finance companies and business firms that borrow funds in
the market.

COMMERCIAL PAPER HOUSES are firms that buy commercial papers; finance the short
term fund requirements of borrowing firms.

FINANCE COMPANIES- are engaged in making short and intermediate terms installment
loans to consumers, factor or finance business receivables and finance the sale of business and
farm equipment.

THREE MAJOR TYPES OF FINANCE COMPANIES


1. Sales Finance-specializing in purchasing from retailer of installment receivables arising
out of retail sales of automobiles and other durable goods sold on installment payment
plan.
2. Business or Commercial Finance Companies- lend directly to a wide variety of
businesses, mainly of small and medium size. Grant short-term loans against the security
of assigned accounts receivables, inventory and equipment.
3. Personal Finance Companies - engage principally in personal loans.

FACTORS performs the financial service known as factoring, which consists of the purchase
of accounts receivables outright without recourse to the seller for credit losses.

INSURANCE COMPANIES-provide a stable source of short term funds. Insurance companies


usually invest on short-term commercial papers and promissory notes.

COMPANY ACCRUALS expense that has been incurred but has not yet been paid. Two
Major forms of accrual 1) accrued wages and salary and 2) accrued taxes.

CORPORATE STOCKS
The firm needs long-term capital for the following requirements:
1. Accumulation of Fixed Assets
2. Expansion of Activities
3. Acquisition of Existing Firm
4. Refinancing its Own Operations
5. Organization of New Ventures

Two Primary Sources of Long-Term Financing:


1. Sale of Stocks
2. Sale of Bonds

STOCK FINANCING is a source of long-term capital. This happens when shares of stocks are
sold to raise funds. Objective is to increase equity capital.

ADVANTAGES OF STOCK FINANCING


1. Does not burden the company with redeeming the stocks at a given date;

BUSINESS FINANCE READING MATERIALS#1 Page 19


2. Stocks are not interest-bearing;
3. Does not require collaterals

CAPITAL STOCKS, DIVIDEND AND RETAINED EARNINGS

CAPITAL STOCK refers to the interest of the owners of a corporation.

Issued Stock a portion of the authorized stock which has been issued and sold
Unissued Stock those which are not yet issued.

DIVIDENDS - refer to the net income of a corporation distributed to stockholders.

RETAINED EARNINGS - portion of net income of the firm not distributed to the stockholders
and allocated for use in some of the firms capital financing requirements.

CLASSES OF CORPORATE STOCKS


1. Common Stock issued by all corporations and which represents the real equity capital.
It has a residual claim (after debts have been paid) to earnings and assets and which
carries the risk of business success or failure.
2. Preferred Stock - is called as such because it has some preferential rights over common
stock.

TYPES OF COMMON STOCKS


1. Classified Common Stock
2. Deferred Stock
3. Voting Trust Certificate
4. Guaranteed Stock
5. Debenture Stock

CLASSIFIED COMMON STOCK made to suit various requirements of the issuing firm and
investors. Common stock classifications are A and B. Companies subject to the 60% minimum
local equity rule simplify their approach to compliance by:
Assigning 60% of its common stock as Class A and can be owned only by nationals; and
The remaining 40% are classified as Class B and may be owned by foreigners.

DEFERRED STOCK is a minor type of issue which entitles the holder to receive dividend
and in the event of dissolution, assets, after the common stockholders have been paid. This type
of stock is generally issued to founders, promoters or managers as a bonus for their efforts in
getting the corporation started.

VOTING TRUST CERTIFICATE are those which are given to trustees of a corporation
when the activities of the corporation are entrusted to them. The certificates provide the trustee
with the power to vote.

BUSINESS FINANCE READING MATERIALS#1 Page 20


GUARANTEED STOCKS - refer to stocks of a corporation wherein the payment of dividends
is guaranteed by another corporation. Guarantees may arise when a corporation purchases or
leases the property of another.

DEBENTURE STOCK is not a stock in the real sense but a debt issue similar to debenture
bonds. They are fixed-interest securities issued by limited companies. Two Main Parts of
Debentures:
1. Fixed Debentures secured by specific assets
2. Floating Debentures - generally secured by a charge of assets of the firm.

ADVANTAGES OF COMMON STOCK FINANCING


1. It does not entail fixed charges.
2. There is no fixed maturity date attached to common stock financing.
3. The firms credit standing is enhanced with the sale of common stock.
4. There are times when common stock is easier to sell than debt.

PREFERRED STOCK is that class of stock which has a claim on assets before common
stock, in the event that the firm is dissolved; and it also has a prior claim to dividends up to a
specified amount or rate. It has some preferential rights over common stock.

PROVISION OF PREFERRED STOCK


1. Claim to Dividends - are entitled in a fixed dividend before common stockholders
receive their dividends
2. Voting Rights - preferred stockholders, in general, do not have right to vote.
3. Subscription Rights - in case of additional issues of stock, some preferred stockholders
have the right to subscribe, while others do not have the same right. This right to
subscribe to additional issues is called pre-emptive right.
4. Callability - preferred stock may be classified as either callable or not-callable;
Callable preferred stocks are those which may be bought back by the issuing
corporation at its option, but at a stated call price. This is not a feature of non-
callable preferred shares.
5. Convertibility- some preferred stocks may also have the feature of convertibility i.e.,
they can be converted into common shares within a certain period after the issuance of
the preferred stock. Convertibility is just another way of classifying preferred stocks. As
such preferred stocks may either be:
Convertible Preferred Stocks preferred stocks that are convertible into
common stocks.
Non-Convertible Preferred Stocks those preferred stocks that are not
convertible into common stocks.
6. Participation preferred stock may be classified as:
Participating Preferred Stock preferred stocks that have the feature of
participating or sharing with the common stock in additional dividends after the
preferred stock has been credited with its regular dividend.
Non-Participating Preferred Stock those preferred stocks that have no feature
of the participating preferred stocks.

BUSINESS FINANCE READING MATERIALS#1 Page 21


7. Classes preferred stocks may be issued in different classes for different purposes. A
preferred share may be identified as class A or B which could mean class A has certain
features that class B does not have.

OTHER STOCK FEATURES AND THEIR CHARACTERISTICS

TREASURY STOCK - is one issued by the corporation, reacquires but not cancelled. It is
useful in cases of stock options, acquisitions, investments, stock splits, stock dividends, and
conversion of convertible securities including warrants.

MAJOR USE OF TREASURY STOCK


1. Stock Options stock option is a right given by the corporation to an individual
allowing him, at his option to buy a certain number of shares of, usually common stock,
from the company within a certain time period.
2. Acquisition - happens when a large firm takes control of a small firm.
3. Investments - refer to purchase of any assets or undertaking of any commitment
4. Stock Split - refers to an issue of new shares to stockholders without increasing total
capital
5. Stock Dividends - refer to dividends paid in the company own stocks including treasury
stock.
6. Conversion of Convertible Securities including Warrants - refer to preferred stocks or
bonds with option to convert into common stock. Treasury stock may be used to satisfy
this option. A stock purchase warrant is an option or a right exercisable by its holder, to
purchase stock at a stated price during a stipulated period of time.

PAR VALUE STOCK

Par Value is the stated value in the shares of corporate stock. Par Value Stock is one with
stated value. Those without stated values are called No Par Value Stocks. When stocks have no
par value, dividends are expressed in peso amounts rather than percentage.

The par value of a share of stock is equal to the minimum price, specified in the corporate
charter, at which it may be sold in order for the stock to be fully paid and be non-assessable.

Par Value is important on two counts:


1. It establishes the amount due the preferred stockholders in the event of liquidation;
2. The preferred dividend is frequently stated as a percentage of the par value.

BOOK VALUE OF STOCK

BOOK VALUE STOCK - refers to the stated value of a stock based on the accounting concepts
of recorded value as reflected in the balance sheet.

The book value of common stock per share is determined by dividing the number of common
shares outstanding into the shareholders equity less the value of any preferred stock.

BUSINESS FINANCE READING MATERIALS#1 Page 22


Example Computation of Common Stock per Share:

Total Shareholders Equity P 400,000,000


Less Preferred Stock 40,000,000
360,000,000
divided by 65 million shares 65,000,000
Book Value Per Shares P 5.54

ECONOMIC VALUE OF STOCK

Economic Value - refers to value of a stock as reflected by its current and future earnings power,
plus any potential recovery of all part of the investment.

MARKET VALUE OF STOCK

Market Value - is the value placed at any one time on a stock traded in a stock exchange or over
the counter or even between parties in an encumbered transaction without duress. The market
value of a stock is a function of the cash expected to flow to stockholders in the future.

CORPORATE BONDS

The Bond is an alternate source of long-term financing. The long-term debt of a firm or the
government which is set forth in writing and under seal is referred to as a Bond.

KINDS OF BOND
1. Government Bonds - are those issued by the government to finance its activities.
2. Corporate Bonds - are those issued by private corporations to finance their long term
funding requirements.

BONDS AS DISTINGUISHED FROM STOCK


As distinguished from stocks, bonds possess the ff. characteristics:
1. A bond is a debt instrument, while stock is an instrument of ownership;
2. Bondholders have priority over stockholders when payments are made by the company;
3. Interest payment due to bonds are fixed, while dividends to stockholders are contingent
upon earnings and must be declared by the board of directions;
4. Bonds have specific maturity date, at which time, repayment of the principal is due. In
contrast, stocks are instruments of permanent capital financing and does not have
maturity dates; and
5. Bondholders have no vote and no influence on the management of the firm, except when
the provisions of the bond and the indenture agreement are not met.

ALTERNATIVE WAYS OF BONDS ISSUANCE


Corporate bonds are generally sold by medium-and-large-size companies to finance plant and
equipment. Small firms do not usually use this financing method.

BUSINESS FINANCE READING MATERIALS#1 Page 23


Bonds are issued through any of the following ways:
1. Public Offering involves selling of corporate bonds to general public through
investment banker, the investment banker provides assistance the issuance of bonds by:
Helping the firm determine the size of the issue and the type of bonds to be
issued;
Establishing the selling price; and
Selling the issue.
2. Private Placement - is a sale of bonds directly to an institution and is a private
agreement between the issuing company and the financial institution without public
examination. Private placement offers the ff. advantages:
The issue can be tailor-made to fit the needs of the issuing firm, as well the
investing firm;
The issue does not have to be registered; and
There are no under writing fees paid by the issuing firm.

CLASSES OF BONDS
By major contractual provisions, bonds may be classified into general types: (1) by types of
security; (2) by manner of participation in earnings; and (3) by method of retirement or
repayment.

BONDS AS TO TYPE OF SECURITY


1. Debenture Bonds - are general credit bonds not secured by specific property. The
earning power of the issuing corporation provides the protection to the debenture
bondholder.
2. Mortgage Bonds - are those which are secured by a lien on specifically named property
such as land, buildings, equipment, and other fixed assets. The specific property pledged
are of two general types:
Real estate - which consist of land and property attached to the land;
Chattels which consist of personal and movable property.
3. Assumed Bonds - There are times when a corporation buys another corporation, or is
merged with another. The liabilities of the deceased corporation are assumed by the
surviving corporation. All bonds previously issued by the deceased corporation are also
assumed by the surviving corporation. These bonds, by virtue of such assumption, are
referred to as assumed bonds.
4. Guaranteed Bond - is a type of bond in which the payment of interest, or principal, or
both, is guaranteed by one or more individuals or corporation. The guarantee merely
assures additional protection on the part of the bondholder.
5. Joint Bonds - There are times when a property is owned jointly by several companies.
The same property may be used as security for a bond issue. The companies bind
themselves jointly as debtors in this type of issue. Bonds falling under such type of issue
are called joint bonds.

BONDS BY MANNER OF PARTICIPATION IN EARNINGS


1. Coupon Bonds - these are bonds having attachments of a series of postdate certificates
(coupons) payable to the bearer for the interest over the life of the bond. These bonds
also referred to as bearer bonds.

BUSINESS FINANCE READING MATERIALS#1 Page 24


2. Registered Bonds - these are bonds where in the names of the owners are recorded on
the transfer book of the company.
3. Income Bonds these are debt instruments with a fixed rate of interest payable only if
earned and declared by the board of directors.
4. Participating Bonds- these are bonds which stipulate a fixed coupon rate but which also
provide a method of receiving additional income over and above this minimum sum.
5. Convertible Bonds - are generally debenture bonds or junior-lien mortgage bonds
wherein the owner has option to exchange his bond for specified number shares of
common stock, or less frequently, preferred stock, or other types of bonds.
6. Bonds With Warrants -bonds may also have warrants, attached to them. The warrant is
an option or a right, exercisable by its holder, to purchase stock at a stated price during a
stipulated period of time. Warrants may be detachable or non-detachable:
Detachable Warrants are those which may be sold or exercised apart from the
bond.
Non-Detachable Warrants cannot be sold or exercised separately from the
bond.
7. Bonds With Junior Security Attached -these are bonds which are issued along with
some shares of stock in a package or block sale. The effect of this arrangement is that
the bondholders have the opportunity of sharing with the stockholders whatever
dividends are declared.

BONDS CLASSIFIED BY METHOD OF RETIREMENT OR REPAYMENT


Bond may also be classified according to the method of retirement. The standard arrangement is
for the bond to mature and the principal be repaid in whole at a definite place and date.
1. Serial Bonds - is one among a group of bonds a part of which mature semi-annually
instead of all on a single date. The effect of maturity in a series is the staggered
repayment schedule of the obligation.
2. Sinking Fund Bonds - bonds may also be gradually retired w/ the provision of a sinking
fund. This arrangement has the effect of periodic repayment of the obligations.
3. Callable Bonds - these are bonds with provisions that the terms of issue can be cancelled
or called. The call privilege enables the issuing company to pay off a bond issue prior to
maturity.
4. Convertible Bonds - these are bonds which may be exchange for the common stock of
the issuing corporation at a fixed price, at a pre-determined redemption date, and at the
option of the bondholder.
5. Perpetual Bonds. These are bonds which cannot be redeemed by demanding repayment.
This type of bonds has no place in the finance of private businesses. It is primarily suited
to the field of public finance where the debtor, the government may be assumed to have a
permanent existence.

REASONS FOR THE USE BONDS


Bonds are used as instruments of long-term financing for any of the following reasons:
1. When the franchise or a license is issued to corporation providing a guarantee of a certain
return on capital investment.
2. When economic condition allow the payment of interest at a rate lower than what is paid
to common stock in the form of dividends.

BUSINESS FINANCE READING MATERIALS#1 Page 25


3. When the present owners of the corporation want to retain their share of the voting
power.
4. When investor resistance to the purchase of common stock is very strong; and when such
resistance is not fund in the sale of bonds.
5. When the degree of safety offered by the issuer attracts investors.
6. When tax advantage are derived from the exercise; and
7. When there is a sufficient demand from institutional investors like banks, insurance
companies, and pre-need firms.

THE INDENTURE AND TRUSTEE

In the study of bond issue, two terms are important:


1. The Indenture - is a contract between the corporation and the trustee on behalf of the
bondholders. The indenture contains the terms of the bond issue covering the obligations
of the corporation, the manner of its fulfillment, the rights and responsibilities of the
bondholders, and the duties of the trustee.
2. The Trustee - is a person who handles monies or property on behalf of another in a trust.
The role of the trustee in a bond issue is to see that the issuing corporation complies with
the provisions in the indenture.

INTERMEDIATE TERM FINANCING

Intermediate Term Financing - refers to borrowings with repayment schedules of more than
one year but less than ten years. In contrast, short-term financing has a repayment schedule of
less than one year, while long-term financing matures in ten or longer.

ADVANTAGES OF INTERMEDIATE TERM FINANCING


1. It is a source of funding for small businesses which do not have access to capital markets.
2. It may be less costly than the raising of funds through bonds or stock flotation.
3. Tax advantages are sometimes derived
4. It allows the firm to borrow funds with only the amounts needed at each stage of
financing.

TERM LOANS BY PRIVATE FINANCIAL INSTITUTIONS


Intermediate term financing is provided by private commercial banks, finance companies, factors
insurance, and pre-need companies.

TERM LENDING BY PRIVATE COMMERCIAL BANKS


Private Commercial Banks (PCBs) constitute an easily identifiable source of term loans. The
extensive network of branches of PCBs provides easy access to intermediate term credit.
Examples of banks with branches spread all over the Philippines are the Philippine National
Bank and Metropolitan Bank and Trust Company.

A Term Loan is a bank advance for a specific period (normally one to ten years) repaid, with
interest, usually by regular periodic payments.

BUSINESS FINANCE READING MATERIALS#1 Page 26


TYPES OF TERM LOAN
There are three types of term loan:
1. Straight Term Loan the straight term loan is granted to finance fixed assets. It is also
granted to fund permanent working capital needs and to temporarily replace liabilities
incurred prior to truly long-term financing. The limit to straight term loan is ten years.
2. Revolving Credit - the revolving credit is a legally assured line of credit, normally
extended for two or three year time periods. The credit line ranges from zero to a stated
figure of the loan. This type of term loan funds working capital requirements.
3. Evergreen Credit - The evergreen credit is a revolving credit arrangement without a
stated maturity. It normally gives the creditor bank an opportunity each year to convert
the credit into a term loan.

TERM LOAN AGREEMENT -Formal loan agreement are required in the granting of term
loans. The loan agreements include the basic features of the loan, such as repayment schedules,
interest rates, and maximum commitments.

The common provisions of loan agreement are the following:


1. The borrower is required to maintain a certain amount of working capital or given current
ratio.
2. The borrower is required to furnish the bank of the creditor with audited annual financial
statements and detailed direct quarterly or monthly statements.
3. The borrower is prohibited to sell or dispose his business properly, except inventories.
4. The borrower is required to provide ample insurance coverage to his business properties
and key employees.
5. Restrictions are imposed to the borrower regarding cash dividends and a ceiling on
officers salaries is imposed.
6. A restriction is imposed on the borrower regarding the expansions of fixed assets beyond
the amount of the term loan.
7. The borrower is prohibited from incurring additional long-term debt or additional lease
obligations.
8. The borrower is not allowed to repurchase the companys own stock.

REPAYMENT OF TERM LOANS


The repayment of term loans depends upon the nature of the business of the borrower. Majority
of ordinary business term loans require equal periodic payments over the life of the loan in
amount adequate to retire the full amount of the principal. The payment schedule is based on the
borrowers projected ability to generate cash. Repayment programs for term loans vary. They
consist of the following:

1. Equal Principal Payments -under this arrangement, the loan is repaid in equal amounts
of principals. The installments are unequal, however, because the interest payment is
largest in the first year and becomes smaller as the principal is gradually paid.
To illustrate, assume a 100,000 loan payable in 10 years at 8% annual interest. The
payment schedule using the equal principal payments programs will appear as follows.

BUSINESS FINANCE READING MATERIALS#1 Page 27


Year Outstanding Interest Due Repayment Total
Principal at at End of of Principal Payment at
Beginning Year at End of End of Year
of Year Year
1 100,000 8,000 10,000 18,000
2 90,000 7,200 10,000 17,200
3 80,000 6,400 10,000 16,400
4 70,000 5,600 10,000 15,600
5 60,000 4,800 10,000 14,800
6 50,000 4,000 10,000 14,000
7 40,000 3,200 10,000 13,200
8 30,000 2,400 10,000 12,400
9 20,000 1,600 10,000 11,600
10 10,000 800 10,000 10,800
2. Equal Amortization - the loan is repaid in equal installment under this type of
repayment. The amount applied to principal is smallest in the first year, and then the
same payments to principal gradually increase through the payment years, the largest of
which is made on the last year. The decreasing payments on interest, however, equalize
the uneven payments on principal.
Using the figures provided on the above, the payment schedule under the equal
amortization arrangement will appear as follows:

Year Outstanding Interest Due Repayment Total


Principal at at End of of Principal Payment at
Beginning Year at End of End of Year
of Year Year
1 100,000.00 8,000.00 6,903.00 14,903.00
2 93,097.00 7,447.76 7,455.24 14,903.00
3 85,641.76 6,851.34 8,051.66 14,903.00
4 77,590.10 6,207.20 8,694.80 14,903.00
5 68,894.30 5,511.54 9,391.46 14,903.00
6 59,502.84 4,760.22 10,142.78 14,903.00
7 49,360.06 3,948.80 10,954.20 14,903.00
8 38,405.86 3,073.46 11,830.54 14,903.00
9 26,575.32 2,126.02 12,776.98 14,903.00
10 13,798.34 1,103.86 13,798.34 14,903.00

3. Balloon Payment - under this repayment program, the loan is repaid in equal
installments for a number of years, then, a large and final payment is made at maturity
date.

The computation of annual payment will appear as follows:

BUSINESS FINANCE READING MATERIALS#1 Page 28


Year Outstanding Interest Due Repayment Total
Principal at at End of of Principal Payment at
Beginning Year at End of End of Year
of Year Year
1 100,000.00 8,000.00 6,000.00 14,000.00
2 94,000.00 7,520.00 6,480.00 14,000.00
3 87,520.00 7,001.60 6,998.40 14,000.00
4 80,521.60 6,441.72 7,558.28 14,000.00
5 72,963.32 5,837.06 8,162.94 14,000.00
6 64,800.38 5,184.03 8,815.97 14,000.00
7 55,984.41 4,478.75 9,521.25 14,000.00
8 46,463.16 3,717.05 10,282.95 14,000.00
9 36,180.21 2,894.41 11,105.59 14,000.00
10 25,074.62 2,005.96 25,074.62 27,080.58

4. Deferred Payment of Principal with Grace Period. The payment of principal under
this program is deferred, although payments on interest are made. This repayment
program suits loans to finance projects with long gestation periods like new orchard
projects and livestock projects.
Under this program the schedule will appear as follows:
Year Outstanding Interest Due Repayment Total
Principal at at End of of Principal Payment at
Beginning Year at End of End of Year
of Year Year
1 100,000.00 8,000.00 - 8,000.00
2 100,000.00 8,000.00 - 8,000.00
3 100,000.00 8,000.00 - 8,000.00
4 100,000.00 8,000.00 11,207.20 19,207.20
5 88,792.80 7,103.42 12,103.78 19,207.20
6 76,689.02 6,135.12 13,072.08 19,207.20
7 63,616.94 5,089.35 14,117.85 19,207.20
8 49,499.09 3,959.92 15,247.28 19,207.20
9 34,251.81 2,740.14 16,467.06 19,207.20
10 17,784.75 1,422.78 17,784.75 19,270.53

A variation of the deferred payment plan allows the borrower a grace period of one to
seven years during which the payment of principal and interest is deferred. A sample
payment schedule of this variation with a grace period of four years is shown below:

(Note: Unpaid interest is added to principal in the succeeding year.)

BUSINESS FINANCE READING MATERIALS#1 Page 29


Year Outstanding Interest Due Repayment Total
Principal at at End of of Principal Payment at
Beginning Year at End of End of Year
of Year Year
1 100,000.00 8,000.00 - -
2 108,000.00 8,640.00 - -
3 116,640.00 9,331.20 - -
4 125,971.20 10,077.69 - -
5 136,048.89 10,883.91 18,616.09 29,500.00
6 64,800.38 9,394.62 20,105.38 29,500.00
7 55,984.41 7,786.19 21,713.81 29,500.00
8 46,463.16 6,049.08 23,450.92 29,500.00
9 36,180.21 4,173.01 25,326.99 29,500.00
10 25,074.62 2,146.85 26,835.70 28,982.55

TERM LENDING BY INSURANCE COMPANIES


Insurance companies are important sources of term loans. The premiums generated constitute
advances to the insurance companies for periods varying from six months to five or more years.
This gives rise to funds held for policy holders by the insurer, funds that must be invested in
some manner.
The Insurance Code specifies the areas of investments allowed for insurance companies.
Intermediate term lending is included in the provision.

TERM LENDING BY FINANCE COMPANIES


Business firms may also obtain intermediate or medium-term financing from finance companies.
Funds which may be derived from such borrowings may be used for the following purposes:
1. As additional working capital;
2. For the purchase of machinery and equipment;
3. For the construction of additional plant facilities;
4. For the retirement of maturing securities;
5. For buying out partners or stockholders; and
6. For the purchase of other companies.

TERM LOANS BY THE GOVERNMENT


The government seeks to identify investment areas which require financial assistance. This is
done for the purpose of achieving development objectives. Most of the financial assistance
provided by the government is coursed through private and government financial institutions.
Government financial institutions have become regular sources of intermediate loans. Among
them are the Land Bank of the Philippines, Social Security System, The Government Service
Insurance System and some others.

CAPITAL MARKET

Capital Market is that portion of the financial market which deals with longer term loanable
funds.

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COMPONENTS OF THE CAPITAL MARKET
1. Bond Market - the market for debt instrument
2. Mortgage Market the portion of the capital market which deals with loans on
residential, commercial and industrial real estate and on farmland.
3. Stock Market - that portion of the capital market where the common and preferred
stocks issued by corporation are traded. It has two components:
The Organized Exchanges
Over-The-Counter Markets

The companies whose stocks are traded in the Philippines Stock Exchange are classified as
follows:
1. Banks
2. Financial Service
3. Communication
4. Power and Energy
5. Transportation Services
6. Construction and Other Related Products
7. Holding Firms
8. Food, Beverages, and Tobacco
9. Manufacturing, Distribution, and Trading
10. Hotel, Recreation, and Other Service
11. Bonds, Preferred And Warrants

CORPORATE SECURITIES

Securities refer to income yielding paper traded on the stock exchange or secondary markets. A
very essential characteristic of a security is its saleability.

Types of Security:
1. Fixed Interest - consisting of debentures, preferred stocks, and bonds including all
government securities.
2. Variable Interest - consisting of common stocks and bonds as well as preferred stocks
with participating feature.
3. Others- like bills of exchange and assurance policies.

PRIMARY MARKET
Primary Market consists of buyers of securities which are issued and offered by the corporation
for the first time to the public. When the primary market buys securities, it actually provides
long-term capital to corporations.

SECONDARY MARKET
Secondary Market refers to the market dealing with the resale and purchase of securities or
other titles to property or commodities

SECURITES OFFERING IN THE CAPITAL MARKET


Firms may obtain long-term capital funds through security offerings in the capital market.

BUSINESS FINANCE READING MATERIALS#1 Page 31


Sources of Capital Funds Obtained By Firms
1. Institutional Sources - consist of banking and non-bank financial institutions
2. Non-Institutional Sources- consist of individual investors.

Securities May Be Disposed of in Two Ways:


1. Public Offering - securities may be directed to the general public or to special publics.
Special Publics- Consist of holders of securities of the issuing corporation and special
groups like offerings, employees, and costumers of the issuing corporation.
2. Private Placement this term refers to the selling of securities by private negotiation
directly to insurance companies, commercial banks, pension funds, large scale corporate
investors and wealthy individual investors.

THE MARKETING OF SECURITIES


Corporate Securities are distributed in two methods:
1. Primary Distribution - when the firms securities are sold for the first time to the public.
May be achieved through any of the following:
Investment Bankers
Private Placement
Individual Investor
2. Secondary Distribution - when the first buyers of securities resell their interests to other
parties. May be achieved through the following:
Stock Exchange
Over-The-Counter Trading

INVESTMENT BANKER- is any person engaged in the business of underwriting securities


issued by other persons or firms. It sometimes referred to investment houses.

UNDERWRITING refers to the act or process of guaranteeing the distribution and sale of
securities of any kind issued by another corporation.

UNDERWRITING AND SELLING THE FIRMS SECURITIES

METHODS FOR UNDERWRITING SECURITIES


1. Negotiated Underwriting the method which refers to that condition when the issuing
firm and the investment banker meet and agree on the terms and conditions of the
underwriting.
2. Competitive Underwriting - is similar to the negotiated underwriting except that the
underwriting group bids against other underwriting groups for the initial purchase of the
securities at a public auction.
3. Commission-Best Efforts Basis - when the investment banker acts as a selling's agent
for the issuer and not as an underwriter, he is paid a commission. The investment banker
agrees to try his best efforts to sell the security.
4. Direct Sale is the instance where issuer sells directly to the public, bypassing the
underwriter entirely.
5. Firm Commitment Basis- is an underwriting agreement wherein the investment house
agrees to purchase the issue from the issuing corporation.

BUSINESS FINANCE READING MATERIALS#1 Page 32


SECURITIES MARKET

SECURITIES MARKET -plays an important role in the distribution of securities. It serves as a


conduit for buying and selling of outstanding issues of securities.

COMPONENTS OF SECURITIES MARKET


1. Auction-Type Markets such as the international and national stock exchanges
2. Negotiation-Type Markets such as the over-the-counter market.

STOCKS EXCHANGE - is an auction-type market where securities are bought and sold. It
found in most capital cities of the world. It exists in most capital cities of the world.

OVER-THE-COUNTER MARKET - is a negotiation-type market where OTC transactions are


carried out directly between dealers. It is provided by dealers who are ready to buy or sell
particular securities at certain prices.

THE MIDDLEMEN OF SECURITIES


The middlemen of securities consist of brokers, dealers, salesmen, and associated persons of a
broker or a dealer. They are required by law to be registered.
1. Broker is a person engaged in the business of buying and selling securities for the
account of others.
2. Dealer means any person who buys and sells securities for his/her own account in the
ordinary course of business.
3. Salesman is a natural person, employed as such or as an agent, by a dealer, issuer or
broker to buy and sell securities.
4. Associated Person of a Broker or Dealer is an employee thereof who, directly
exercises control of a supervisory authority but does not include a salesman, or an agent
or a person whose functions are solely clerical.

THE PHILIPPINES STOCK MARKET


The market is served by the Philippine Stock Exchange (PSE). Trading in the PSE is undertaken
daily except Saturdays, Sundays and holidays. The trading of shares are in terms of fixed
minimum amounts called board lots. Trading in units lower than the minimum standard unit of
trading or odd-lot is also allowed. Odd-lots are result of fractional issuance of stock dividends
or special arrangements or when what was once a board lot becomes an odd lot because of a
change in the price range. The prices of stocks and the volume of trading in the securities
markets vary from day to day depending on supply and demand. The method of transaction is a
double auction market between buyer and a seller who are represented by brokers.

The Securities and Exchange Commission (SEC) - is the government agency tasked with
regulating trading in the securities market.

The legal framework used in the implementation of state policy regarding securities trading is the
Securities Regulation Code.

BUSINESS FINANCE READING MATERIALS#1 Page 33


LEASING
Leasing is a very important source of long-term financing. The existence of more than 300
leasing companies in the Philippines indicates the popularity of leasing as a financing option.

LEASE - is a negotiated contract between the owner (lessor) of the property allowing the firm
(the lessee) the use of that property for a specific period of time for a specific rental.

The lessee is the party that uses, rather than the one who owns the leased property. The lessor is
the owner of the leased property.

TYPES OF LEASES
1. The Financial Lease - is a non-cancelable document that obligates the lessee to provide
periodic rental payments during the basic lease term.
2. The Operating Lease - also sometimes called service lease, is a kind of lease usually
cancelable by the lessee with proper notice and that the lessor usually maintain the asset.
3. A Sale and Leaseback - is a special type of lease. When a firm owns an asset, sell it to
another, then uses the same asset on a lease agreement with the new owner, such
arrangement is called sale and leaseback.
4. Net and Gross Leases leases can either be net or gross. Under the net lease agreement,
the lessee bears the expenses associated with the assets, such as taxes, repairs and
maintenance and insurance. These expenses are borne by the lessor in a gross lease.

BASIC LEASE PROVISIONS


A typical lease agreement contains some or all of the following provisions:
1. The period over which the asset is to be leased.
2. The rental payments and the payment dates.
3. The assignment of responsibility to one of parties for such associated costs as taxes and
maintenance.
4. Security provision like prohibitions against the lessee incurring additional debt, paying
dividends, or reacquiring common stock.
5. Escalation clauses allowing the lessor to raise the periodic rental payments at some pre-
determined dates over the life of the lease, or in response to increases in cost.
6. Options allowing the lessee to renew the lease or purchase the asset.

ADVANTAGES OF LEASING
1. Lessor Bear Ownership Risks
2. Flexibility
3. Piecemeal Financing.
4. Avoidance of Restriction Accompanying Debt
5. Evasion of Budgetary Restrictions
6. Cash Made Available For More Profitable Investment.
7. Tax Advantages Over Ownership
8. Lease Does Not Appear As Debt.

DISADVANTAGES OF LEASING
1. It is more costly than if the firm has purchased the asset;

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2. The benefits of depreciation, investment, tax credits, and salvage value are not availed of
by the lessee; and
3. Even if the firm can abandon unprofitable operation, it cannot abandon the lease
payments.

WHEN LEASE FINANCING MAY BE UTILIZED


Lease financing must not be utilized without considering other financing alternatives. It must be
used only when it is financially defensible. It must offer of the following:
1. There must be cost savings over borrowing;
2. It must be available where an equivalent amount of debt financing is not available; or
3. Some offsetting advantage justifying high cost.

FINANCIAL ANALYSIS
The firms financial condition is the concern of various groups consisting of the owners or
stockholders, the creditors, the government, the public, and the management of the firm.
Financial Analysis is a way by which various groups would know the financial condition of the
firm.

FINANCIAL ANALYSIS DEFINED


The purpose of financial analysis is to diagnose the current and the past financial condition of the
firm to give some clues about its future condition. The output of financial analysis is useful tool
in decision-making.

FINANCIAL ANALYSIS may be defined as the process of interpreting the past, present, and
future financial condition of the company.

TYPE OF ANALYSIS
In the analysis of the financial standing of the firm, procedures may be categorized as follows:
1. Single-Period Analysis - refers to comparison and measurements based upon the
financial data of a single period. It reveals the financial position and relationship as of a
given point or period of time.
2. Comparative or Trend Analysis - compares and measures items on the financial
statements of the two or more fiscal periods. The improvement or lack of improvement in
financial position and in the result of operation is determined.

FINANCIAL RATIOS
A very useful method in financial analysis is the use of financial ratios. The relation of one part
of the financial statement to another expressed through the financial ratios. The net profit, for
instance, may be measured in relation to gross sales.

FINANCIAL RATIO - may be defined as a relationship between two quantities on a firms


financial statement or statements, which is derived by dividing one quantity by another.

FUNCTION OF FINANCIAL RATIOS


Financial ratios serve the following purposes:
1. As a starting point for detailed for financial analysis;

BUSINESS FINANCE READING MATERIALS#1 Page 35


2. Help to diagnose the situation;
3. To monitor performance;
4. To help plan forward; and
5. To reduce the amount of data to workable form and to make the data more meaningful.

CLASSES OF FINANCIAL RATIOS


Financial ratios are classified as either
1. Liquidity Ratios are used to determine the ability of the firm to meet the resources at
its command.
2. Activity Ratios are used to measure how effectively the firm employs the resources at
its command.
3. Profitability Ratios - are those which measure managements effectiveness as shown by
the return generated on sales and investment.
4. Solvency Ratios - refers to those which measure the ability of the firm to pay its debts
eventually, if it is not paid on time.

LIQUIDITY RATIOS
Those classified as liquidity ratios are the followings:
1. Current Ratio - this ratio indicates the margin of safety by which a firm can meet its
obligations falling due within the year from such assets easily convertible into cash
within the year.
Current Ratio = Current Asset / Current Liabilities
2. Acid Test Ratio - also called quick ratio, is the ratio of cash assets to current liabilities. It
is calculated by deducting inventories from current assets and dividing the remainder by
current liabilities.
Acid Test or Quick Ratio = Current Assets Inventory / Current Liabilities
3. Sales To Receivable Ratio - This ratio may be computed in two ways:
In terms of annual turnovers the formula for computing annual turnover is:
Annual Turnover = Annual Net Sales / Accounts Receivable
In Terms of Collection Period it is calculated with the use of the following
formula:
Collection Period = 360 Days / (Sales / Accounts Receivables)
4. Sales To Inventory Ratio - this ratio is measure of inventory turnover. Firms with
excessive inventories will show a low ratio. It is computed as follows:
Sales Inventory Ratio = Annual Receipts from Sales / Inventory at the End of Year
5. Inventory To Net Working Capital Ratio -this ratio shows the proportion of net current
assets tied up in inventory, indicating the potential loss to the company in the event of a
decline in inventory values. It is calculated by dividing net working capital into the
inventory figures. It is calculated as follows:
Inventory to Net Working Capital Ratio = Inventory / (Current Assets -
Current Liabilities)

ACTIVITY RATIOS
Four types of ratios are classified as activity ratios. These are the followings:
1. Sales To Receivable Ratio see liquidity ratios
2. Sales To Inventory Ratio - see liquidity ratios

BUSINESS FINANCE READING MATERIALS#1 Page 36


3. Inventory To Net Working Capital Ratio - see liquidity ratios
4. Sales to Net Worth Ratio- the ratio of the net sales to owners equity represents the
turnover of owners equity. The formula used is as follows:
Net Sales per Peso of Owners Equity = Net Sales / Tangible Owners Equity

PROFITABILITY RATIOS
Ratios indicating profitability consist of the following:
1. Sales To Inventory Ratio - see liquidity ratios
2. Profit To Net Sales - this ratio, also called profit margin on sales, computed by dividing
net income after the taxes by sales. The result is profit margin expressed in percentage.
Profit Margin = Income Sales / Sales
3. Profit To Net Worth - This ratio, also referred to as return on net worth ratio, measures
the rate of return on the owners investment. The formula is as follows:
Return on Net Worth = Net Income/Net Worth
4. Profit To Assets - this ratio is also called return on total assets ratio. It measures the
return on total investment in the firm. The formula is as follows:
Return on Total Assets = Net Income / Total Assets

SOLVENCY RATIOS
The solvency ratios include the followings:
1. Current Ratio - see liquidity ratios
2. Sales To Inventory Ratio - see liquidity ratios
3. Inventory To Net Working Capital Ratio see activity ratios
4. Debt To Net Worth Ratio this ratio shows the relative proportion of debts to equity. In
effect, it measures the debts exposure of the firm. The formula is as follows:
Debt Net Worth Ratio = Total Debt / Net Worth
5. Net Worth To Fixed Assets Ratio - this ratio indicates to what extent fixed assets have
been financed by the contribution of the stockholders. The ratio is calculated with the use
of a formula as follows:
Net Worth To Fixed Assets = Net Worth / Fixed Assets
6. Sales To Net Worth Ratio - see activity ratios

COMPARATIVE RATIO ANALYSIS


Financial ratios may be made more useful by comparing them to the financial ratios of other
firms in the industry. If the firms ratio is different from that industry, cause of the deviation
should be investigated. Comparisons may be made either with those of selected firms or with
averages for the industry. The SEC is a very useful source of financial data relating to registered
firms.

BUSINESS RISK

Risk may be defined into two ways. First, it may be viewed as the variability in possible
outcomes of an event based on chance. The second definition of risk refers to uncertainty
associated with an exposure to loss.

BUSINESS FINANCE READING MATERIALS#1 Page 37


METHODS OF HANDLING RISK
Experiences have led mankind to adopt ways of handling risk. The methods are more
pronounced when applied to business finance. These methods are the following:
1. Risk may be avoided;
2. Risk may be retained;
3. Hazard may be reduced;
4. Loss may be reduced;
5. Risk may be shifted; and
6. Risk may be reduced

INSURANCE AS DEVICE FOR HANDLING RISK


The most common device used in handling risk is insurance. Most risks that are related to
business operations may be covered by insurance policies currently sold in market. In spite of
this, however, the Filipino businessman is not very keen in availing of the services provided by
insurance firms.

INSURANCE may be defined in various ways. From the legal viewpoint, a contract of
insurance is an agreement whereby one undertakes for a consideration, to indemnify another
against loss, damage, or liability arising from an unknown or contingent event.
From the viewpoint of business economics, insurance is an economic device used to reducing
risk by combining a sufficient number of exposure units to make their individual losses
collectively predictable.

THE INSURANCE POLICY


The Insurance Policy is the written instrument in which contract of insurance is set forth. It
contains the following:
1. Declarations - the nature of the risk is described in the declarations which are usually
found on the first page of an insurance policy.
2. Insuring Agreements - is that part of the policy which states what the insurer agrees to
do and the major conditions under which it agrees.
3. Conditions - conditions may be general or specific.
4. Exclusions - exclusion is a provision or part of the insurance contract limiting the scope
of coverage.

TYPES OF INSURANCE COVERAGE


Insurance contracts may be classified as either life or non-life.
1. Life Coverage - are those relating directly to the individual. The risk covered is the
possibility that some peril may interrupt the income that is earned by an individual. The
perils relating to life coverages consist of the following:
Death
Accidents and Sickness;
Unemployment; and
Old Age.
2. Non-life Coverage - it refers to insurance other than life. Included in non-life coverage
are:
Fire and allied risk;

BUSINESS FINANCE READING MATERIALS#1 Page 38


Marine
Casualty
Surety; and
Liability

Non-life insurance is distinguished from life insurance in that life insurance covers perils that
may prevent one from earning money with which to accumulate property in the future, while
non-life insurance covers property that is already accumulated. Non-life insurance is also
referred to as general insurance.

BASIC TYPES OF LIFE INSURANCE CONTRACTS


There are quite a number of life insurance policies which are offered for sale in the market to
meet the varying needs of individuals and business firms.
Life Insurance Contracts consist of four basic types:
1. Whole Life Insurance a kind of life insurance which is kept in force until death so
long as premiums are paid, regardless of age and the time period. Based on the method of
premium payment, there are three classes of whole life insurance policies:
Single-Premium Whole Life Policies - are those for which, in exchange for one
premium, the insurer promises to pay the claim whenever death occurs
Continuous-Premium Whole Life Policies - are those for which the insured pays
the same premium amount continuously as long as he is alive.
Limited Payment Whole Life Policies - belong to the type of insurance plan
under which the premiums are paid for a limited period of years, after which no
further premium payments need to be made.
2. Term Insurance - a term insurance policy is a contract between the insurance and
insurer whereby the insurer promises to pay the face amount of the policy to the third
party (the beneficiary) if the insured dies within a specified time periods. Term insurance
policies are as follows:
Straight Term Policies -which are written for a specific number of years and then
automatically terminated;
Long Term Policies -which are written to terminate at some specified age of the
insured, commonly 65;
Renewable Term Insurance - which may be renewed by the insured before
expiry date, without again proving insurability;
Convertible Term Policies - which may be converted into whole life or
endowment insurance within specified period, without evidence of insurability;
Increasing Term Insurance - the policy amount which increase monthly or
yearly; and
Decreasing Term Insurance - the face value of which reduces periodically, either
monthly or yearly.
3. Endowment Insurance - is a contract under which the insurer promises to pay the
beneficiary a stated sum if the insured dies during the policy term or to the insured if the
policy term is survive. The policy term is also referred to as the endowment period.
Endowment Insurance may be classified according to the following:
The term for which they are written may vary from 5 to 40 years.

BUSINESS FINANCE READING MATERIALS#1 Page 39


The designated age of the maturity to which they are written, such as 60 to 65
years; and
The period of premium payment, such as the limited payment endowment, where
the endowment is payable at death or the end of the endowment period
4. Annuities -an annuity is a series of payments made at certain specified intervals.

BUSINESS AND THE USE OF LIFE INSURANCE


The employees of the firm constitute a very important investment. Possible liabilities of the
company arise when employees are injured or killed in work-related accidents. The moral
obligation of the employer is to provide for such type of needs. If these are not provided for
through insurance, the funds of the firm which ae earmarked for other uses may be jeopardized.
The various types of life insurance contracts available provide solution to such possible
difficulties.

1. FIRE INSURANCE
Fire is one of the most destructive perils known to man. A fire insurance contract covers all
direct losses and damages by fire or lighting and by removal from premises endangered by
fire. In the attempt to rescue property, losses due to theft may occur. Such losses are also
covered by a fire policy. Other perils covered by fire insurance contract:
1. Earthquake fire
2. Earthquake shock
3. Windstorm, typhoons, and flood;
4. Riot and strike damage and riot fire; and
5. Explosions

2. MOTOR CAR INSURANCE


Most business firms cannot avoid the ownership of motor vehicles. Conveyances are needed
by the firm for transporting goods and persons. Owning a vehicle however entails some
risks which include possible injuries to persons or damage to properties.

Motor Vehicle Insurance Coverage


1. Compulsory Third Party Liability (CTPL)
2. Third Party Property Damage (TPPD)
3. Passenger Liability (PL)
4. Own Damage (OD) and Theft
5. Personal Accident Coverage for Drivers and Passengers of Private and Commercial
Vehicles.

3. MARINE INSURANCE
Business firms involved in transporting commodities from one seaport to another require
protection from possible losses of such commodities. This type of applicable insurance
coverage is called marine insurance.

Marine Insurance Coverage


1. Insurance Against Loss or Damage
2. Marine Protection and Indemnity Insurance

BUSINESS FINANCE READING MATERIALS#1 Page 40


4. GENERAL LIABLITY INSURANCE
General Liability business firms may at times be subjected to liability claims by other parties.
Damages paid to claimants are sometimes enough to cause bankruptcy to the firm.
Business Liability Forms:
Owners, Landlord, and Tenants Form
Manufacturers and Contractors Form
Comprehensive General Liability Form
Contractual Liability Form
Owners and Contractors Protective Liability Insurance
Products and Completed-Operations Liability Form
Products Recall Insurance
Personal Injury Liability Policy
Storekeeper Liability Policy
Dramshop Liability Policy

5. SURETY BONDS
The firm may also be exposed to possible losses involving the following:
The mishandling or misappropriation of goods or funds by employees
The non-performance of a party who has entered into an agreement with the firm.
The first type of exposure to loss may be covered by fidelity bonds, while the second type
may be covered by surety bonds.
Fidelity Bond -is one that covers an employee or employees in position of probate
trust and it guarantees the employer against loss up to the penalty of the bond should
the employees bonded be proven dishonest.
Surety Bond - guarantees to the obligee that the principal named in the bond will
perform a certain obligation and if he fails to do so, the surety will perform the
obligation or pay the damages up to the amount of the bond.

6. MISCELLANEOUS INSURANCE LINES


There are other types of insurance coverages which may protect the firm from possible
financial losses. These are the following:
Crime Insurance - protects owners of property against losses due to its being
wrongfully taken by someone else
Glass Insurance - the large amounts cash outlay invested in glass used for light,
display, and ornamentation exposes the owner to losses which may be substantial.
Boiler and Machinery Insurance - is a type of insurance contract which provides
protection against loss resulting from the accidental bursting or breaking of a great
variety of apparatus.
Credit Insurance - is a contract whereby the insurer promises, in consideration of
premium paid, and subject to specified conditions as to the persons to whom credit is
to be extended, the insured, wholly or in part against the loss that may result from the
insolvency of persons to whom me may extend credit within the term of insurance.

BUSINESS FINANCE READING MATERIALS#1 Page 41


BUSINESS FAILURE, REORGANIZATION AND LIQUIDATION
To some firms, environmental changes bring unwanted consequences and one of these is
business failure.

BUSINESS FAILURE DEFINED AND CLASSIFIED


Business failure refers to the following:
1. All industries and commercial enterprises that are petitioned for bankruptcy in the court.
2. Concerns which are forced out of the business through such actions in the courts as
foreclosure, execution, and attachments with insufficient assets to cover all claims.
3. Concern involved in actions in the court and other governments agencies (like the
Securities and Exchange Commission and the Central Bank) such as receivership,
reorganization, or arrangements.
4. Voluntary discontinuance with known loss to creditors; and
5. Voluntary compromises with creditors out of the court.

CLASSES OF BUSINESS FAILURE


Business Failures may be classified either as economic or financial:
1. Economic Failures - this happens when the firms revenues no longer cover cost.
2. Financial Failures this happens when the firms becomes insolvent or is unable to pay
its debts. Financial failure is a result of any of the following.
When he firms assets are more than its liabilities, but with the assets not liquid
enough to settle its maturing obligations; and
When the firms assets are less than its liabilities

CAUSES OF FAILURES
Businesses may fail for one reason or another. The reasons, however, could be external or
internal:
1. External Causes of Failure failure may be due to nay of the following external causes:
Recessions
Changes in Government Regulation or Contracts
Burdensome Taxes or Tariffs
Court Decisions
Legislation Unfavorable to the Specific Type of Business or to Business in
General
Strikes or Boycotts
Labor Costs
Dishonest Employees
Disasters or Acts of God
2. Internal Causes of Failures - the internal causes of business failure consist of the
following:
Overcapitalization in Debt
Undercapitalization in Equity
Inefficient Management Of Income
Inferior Merchandise
Improper Costing with Excessive Expenditures

BUSINESS FINANCE READING MATERIALS#1 Page 42


Errors of Judgement Concerning Problems or Expansion
Insufficient Pricing Decisions
Inability to Improve a Weak Competitive Position

SYMPTOMS OF FAILURES
Statistical data are sometimes useful in identifying indications of impending business failure. In
this regard, financial ratios play an important role.
Cash Flow to Total Debt- viable firms have higher cash flows to total debt ratio. When
this ratio gets lower, the financial standing of the firm weakens, and when it gets even
lower, failure approaches.
Market Price - approaching failures is also indicated by a declining market price of the
firms stocks.
Working Capital to Total Assets - when the ratio declines, failure approaches. The
decline reflects the inadequacy of working capital.
Retained Earnings to Total Assets -retained earnings provide a source of funding for
unexpected costs, delays, or credit crunches.
Earnings before Interest and Taxes to Total Assets - this ratio reflects the adequacy of
cash flow in relation to the firms liabilities. A lower ratio means a lesser chance of
settling debts.
Market Value of Equity to Book Value of Debt - when debts are used excessively, the
market value of the stock goes down because of increased financial risks.
Sales to Total Assets a decreasing sale to total assets ratio reflects the shrinking market
for product. As the ratio gets lower, the firm approaches failure.

REMEDIAL ACTIONS FOR BUSINESS FAILURES


In case of business failure, the remedies may either be:

1. Rehabilitation - is an attempt to keep the firm going. It may be achieved through any of
the following:
Reorganization refers to a formal proceeding under the supervision of a court,
including short-term liabilities, long-term debts and stockholders equity, in order
to correct gradually the firms immediate inability to meet its current payments.
Reorganization plans may call for:
Refinancing - refers to the replacement of outstanding securities by the
sales of new securities. Refinancing may be classified as:
Refunding - refers to the sales of new bond issue to replace an
existing bond issue.
Funding is the retirement of a preferred stock with the proceeds of
borrowing.
Reverse Funding - the issuance of common stocks as a means of
paying off outstanding bond issue
Recapitalization - is undertaken when a group of existing security holders
accepts a new issue in voluntary exchange for the issue it now holds.

Voluntary Arrangements - when creditors and stockholders agree to give the


firm a chance to get back on the right track under a mutually accepted plan.

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Voluntary agreements may fall under any of the following:
Extension payment dates are postponed on at least a portion of the
firms short-term liabilities including maturing long-term debts.
Composition- the creditors accept a partial payments in full settlement of
their clams, thereby releasing the debtors firm from its obligations to
them.
Creditor Management occurs when the committee of the creditors
takes over the firms. The creditor management tries to get the business
back on its feet.

2. Liquidation - occurs when a firm dissolves and cease to exist and its assets are sold.
Liquidation may be accomplished through any of the followings:
A Voluntary Agreement called Assignment - an assignment is out-of-the-court
settlements where the creditor selects a trustee to sell the assets and distribute the
proceeds.
A Formal Proceeding Called Liquidation under Bankruptcy - bankruptcy it
is a legal process by which a person or business that is unable to meet financial
obligations is relieved of those debts by the court.

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