Lecture Notes for Basic Finance Chapters 1 – 3

AY 2018-2019 Second Semester

Finance can be defined as the science and art of managing money. (Gitman & Zutter, 2012)

Budgeting is the act of estimating revenue and expenses over a period of time.

Forms of business organizations:

• Sole Proprietorship - A business owned by one person and operated for his or her own profit.
• Partnership - A business owned by two or more people and operated for profit.
• Corporation – An entity created by law owned by shareholders.

Privately owned corporations are often owned by family members whose stocks may not be offered to outsiders
unless consent by the family members is secured.

Publicly listed companies, companies which are publicly listed are owned by unrelated investors and are traded
in organized exchanges like the Philippine Stock Exchange.

While there are many stockholders, there is generally a group of investors or a family which controls each listed
company. For example, in the case of BPI, the biggest stockholder is Ayala Corporation and in the case of
Banco De Oro, it is SM Investment Corporation. Prices of stocks of listed corporations are driven by several
factors such as the earnings of the companies, the prospects of the industry where these companies operate,
the general market sentiment, and the economic prospects of the country, among others.

Factors that influence market prices:

 • Company A is profitable but generated negative cash flows which resulted from the uncollected
accounts receivable of PHP100,000. Without adequate cash inflows to meet its obligations, the
company will face liquidity problems, regardless of its level of profits.
• Company B on the other hand has a positive cash flow but is unprofitable. This is a result of the
company’s delay in payment of its costs. Accordingly, the Company will soon have to pay the remaining
PHP100,000 liability and its cash will no longer be sufficient. Again, without adequate cash inflows to
meet its obligations, the company will face liquidity problems.
• Company C is profitable and has a positive cash flow. Based on the information provided, Company C
seems to be the best.

Good liquidity and reasonable leverage position.

Liquidity and leverage refers to the company’s management of the type and amount of assets and liabilities
that it will hold in the course of its operations.

Dividends.

• Holders of shares receive dividends from a corporation as returns on their investments in form of cash
or other properties. Companies which have better dividend policies are generally more attractive than
companies who do not pay out dividends.
• Note that there may be times that companies do not pay out dividends because of future expansions.
Same with the other factors affecting share price, dividend policies should go hand in hand with other
factors in determining market price.

Competent management.

• Competent managers may have any of the following attributes: 1) visionary 2) decisive 3) people-
oriented, 4) inspiring, 5) innovative, 6) respected and 7) experienced/seasoned manager.

Corporate plans that improve the business prospects.

• Example: Company A which is in the business of selling Halo-halo in the Dapitan area (or any other
area) for 5 years. Company A is consistently earning profits and has a positive cash flow. When asked
how Company A sees itself after 5 more years, Company A answered that it would continue to sell Halo-
halo in Dapitan (or any other area).
• On the other hand, Company B sells Buko Juice in Katipunan area (or any other area different from
Company A’s area) for 5 years. Company B is consistently earning profits and has a positive cash flow.
When asked how Company B sees itself after 5 more years, Company B answered that it has generated
enough cash to expand its business to Cubao area (or any other area) to take advantage of the growing
demand of Buko Juice in Cubao.
• Between Company A and Company B, which would be a better investment? Company B. Since it has
more concrete future prospects allowing investors to hope for better revenues and net income.

External Factors

• These factors influence the general reaction of investors in making an investment decision.
• Its effect is not only to a specific company but on all companies or a group of companies under similar
circumstances.
• Such factors are a result of the environment a company operates in rather than the decisions of the
company’s management.
Role of Financial Management

• Financial management deals with decisions that are supposed to maximize the value of shareholders’
wealth. (Cayanan)
• These decisions will ultimately affect the markets perception of the company and influence the share
price.
• The goal of financial management is to maximize the value of shares of stocks.
• Managers of a corporation are responsible for making the decisions for the company that would lead
towards shareholders’ wealth maximization.

CORPORATE ORGANIZATION STRUCTURE

Shareholders: The shareholders elect the Board of Directors (BOD). Each share held is equal to one voting
right. Since the BOD is elected by the shareholders, their responsibility is to carry out the objectives of the
shareholders otherwise, they would not have been elected in that position..

Board of Directors: The board of directors is the highest policy making body in a corporation. The board’s
primary responsibility is to ensure that the corporation is operating to serve the best interest of the
stockholders. The following are among the responsibilities of the board of directors:

• Setting policies on investments, capital structure and dividend policies.

• Approving company’s strategies, goals and budgets.
• Appointing and removing members of the top management including the president.
• Determining top management’s compensation.
• Approving the information and other disclosures reported in the financial statements (Cayanan, 2015)
President (Chief Executive Officer): The roles of a president in a corporation may vary from one company to
another. Among the responsibilities of a president are the following:

• Overseeing the operations of a company and ensuring that the strategies as approved by the board are
implemented as planned.
• Performing all areas of management: planning, organizing, staffing, directing and controlling.
• Representing the company in professional, social, and civic activities.

VP for Marketing: The following are among the responsibilities of VP for Marketing

• Formulating marketing strategies and plans.

• Directing and coordinating company sales.
• Performing market and competitor analysis.
• Analyzing and evaluating the effectiveness and cost of marketing methods applied.
• Conducting or directing research that will allow the company identify new marketing opportunities, e.g.
variants of the existing products/services already offered in the market.
• Promoting good relationships with customers and distributors. (Cayanan, 2015)

VP for Production: The following are among the responsibilities of VP for Production:

• Ensuring production meets customer demands.

• Identifying production technology/process that minimizes production cost and make the company cost
competitive.
• Coming up with a production plan that maximizes the utilization of the company’s production facilities.
• Identifying adequate and cheap raw material suppliers. (Cayanan, 2015)

VP for Administration: The following are among the responsibilities of VP for Administration:

• Coordinating the functions of administration, finance, and marketing departments.

• Assisting other departments in hiring employees.
• Providing assistance in payroll preparation, payment of vendors, and collection of receivables.
• Determining the location and the maximum amount of office space needed by the company.Identifying
means, processes, or systems that will minimize the operating costs of the company. (Cayanan, 2015)

The role of the VP for Finance of the Financial Manager is to determine the appropriate capital structure of
the company. Capital structure refers to how much of your total assets is financed by debt and how much is
financed by equity.

Recall that Assets = Liabilities + Owner’s Equity.

• To be able to acquire assets, our funds must have come somewhere. If it was bought using cash from
our pockets, it is financed by equity.
• On the other hand, if we used money from our borrowings, the asset bought is financed by debt.

Investments may either be short term or long term.

• Short term investment decisions are needed when the company is in an excess cash position.
• To plan for this, the Financial Manager should be able to make use of Financial Planning tools such as
budgeting and forecasting:
 • Moreover, the company should choose which type of investment it should invest in that would provide
a most optimal risk and return trade off.
• Long term investments should be supported by a capital budgeting analysis which is among the
responsibilities of a finance manager.
o Capital budgeting analysis is a tool to assess whether the investment will be profitable in the
long run. This is a crucial function of management especially if this investment would be
financed by debt.
o The lenders should have the confidence that the investments that management will push
through with will be profitable or else they would not lend the company any money.
• Investing
• Short term investments:
Plan for expected excess in cash using Financial Planning tools such as budgeting and forecasting
Choose which type of investment should it invest in that would secure the best profits

• Long term investments:

Prepare a capital budgeting analysis to determine if the long-term investment will be profitable B.

• Operating - determine how to finance working capital accounts such as accounts receivable and
inventories (short term vs. long term)

• Operating decisions deal with the daily operations of the company. The role of the VP for finance is
determining how to finance working capital accounts such as accounts receivable and inventories. The
company has a choice on whether to finance working capital needs by long term or short term sources.
Why does a Financial Manager need to choose which source of financing a company should use? What
do they need to consider in making this decision?
o Short Term sources are those that will be payable in at most 12 months. This includes short-term
loans with banks and suppliers’ credit. For short-term bank loans, the interest rate is generally
lower as compared to that of long-term loans. Hence, this would lead to a lower financing cost.
o Suppliers’ credit are the amounts owed to suppliers for the inventories they delivered or services
they provided. While suppliers’ credit is generally free of interest charges, the obligations with
them have to be paid on time to maintain good supplier relationship. Such relationships should
be nurtured to ensure timely delivery of inventories.
o Short term sources pose a trade-off between profitability and liquidity risk. Because this source
matures in a short period, there is a possibility that the company may not be able to obtain
enough cash to pay their obligation (i.e. liquidity risk).
o Long term sources, on the other hand, mature in longer periods. Since this will be paid much
later, the lenders expect more risk and place a higher interest rate which makes the cost of long-
term sources higher than short term sources. However, since long term sources have a longer
time to mature, it gives the company more time to accumulate cash to pay off the obligation in
the future.
o Hence, the choice between short- and long-term sources depends on the risk and return trade
off that management is willing to take.

There are two types of liquidity risk:

a. Risk that the company will fail to pay its short-term obligations.
 b. Risk that you will not be able to sell investments in financial assets immediately.

• Dividend Policies. Recall that cash dividends are paid by corporations to existing shareholders based
on their shareholdings in the company as a return on their investment. Some investors buy stocks
because of the dividends they expect to receive from the company. Non-declaration of dividends may
disappoint these investors. Hence, it is the role of a financial manager to determine when the company
should declare cash dividends.
o Before a company may be able to declare cash dividends, two conditions must exist:
1. The company must have enough retained earnings (accumulated profits) to support cash
dividend declaration.
2. The company must have cash.

What will affect the decision of management in paying dividends? Be reminded that dividends come from the
company’s cash and availability of unrestricted retained earnings.

- Answer:

• Availability of financially viable long-term investment

• Access to long term sources of funds
• Management’s Target Capital structure

• One of the functions of a finance manager is investing and its available cash may be used to invest in
long term investments that would increase the profitability of the company. Some small enterprises
which are undergoing expansion may have limited access to long term financing (both long term debt
and equity). This results to these small companies reinvesting their earnings into their business rather
than paying them out as dividends.
• On the other hand, a company which has access to long term sources of funds may be able to declare
dividends even if they are faced with investment opportunities. However, these investment
opportunities are generally financed by both debt and equity.
• The management usually appropriates a portion of retained earnings for investment undertakings and
this may limit the amount of retained earnings available for dividend declaration.
• Creditors are not willing to finance entirely the cost of a company’s long-term investment. Hence, the
need for equity financing (e.g. internally generated funds or issuance of new shares).
• Examples of these companies are publicly listed companies such as PLDT, Globe Telecom, and Petron.
PLDT and Globe are two of the Philippine listed companies which have generously distributed cash
dividends for the last five years (information as of 2014).
• For companies which have limited access to capital and have target capital structure, they may end up
with a residual dividend policy. This means that when companies are faced with investment
opportunities, internally generated funds will be used first to finance these investments and dividends
can only be declared if there are excess funds.

✓ Financial Markets – organized forums in which the suppliers and users of various types of funds can
make transactions directly
 ✓ Financial Institutions – intermediaries that channel the savings of individuals, businesses, and
governments into loans or investments.
✓ Private Placements - the sale of a new security directly to an investor or group of investors.
✓ Public Offering - The sale of either bonds or stocks to the general public.
✓ Financial Instruments – is a real or a virtual document representing a legal agreement involving some
sort-of monetary value (Source: Investopedia - Sharper Insight. Smarter Investing. | Investopedia. (2016).
Investopedia. Retrieved 8 May 2016, from http://investopedia.com). These can be debt securities like
corporate bonds or equity like shares of stock.

THE FINANCIAL SYSTEM

Financial Instruments

When a financial instrument is issued, it gives rise to a financial asset on one hand and a financial
liability or equity instrument on the other.

- A Financial Asset is any asset that is:

✓ Cash
✓ An equity instrument of another entity
✓ A contractual right to receive cash or another financial asset from another entity.
✓ A contractual right to exchange instruments with another entity under conditions that are potentially
favorable. (IAS 32.11)
✓ Examples: Notes Receivable, Loans Receivable, Investment in Stocks, Investment in Bonds

A Financial Liability is any liability that is a contractual obligation:

✓ To deliver cash or other financial instrument to another entity.

✓ To exchange financial instruments with another entity under conditions that are potentially unfavorable.
(IAS 32)
✓ Examples: Notes Payable, Loans Payable, Bonds Payable
An Equity Instrument is any contract that evidences a residual interest in the assets of an entity after
deducting all liabilities. (IAS 32)

✓ Examples: Ordinary Share Capital, Preference Share Capital

a. Who are the holders of Financial Asset? - Answer: Suppliers of Funds

b. Who are the makers of Financial Liabilities and Equity instruments? - Answer: Users of Funds

When companies are in need of funding, they either sell debt securities (or bonds) or issue equity
instruments. The proceeds from the sale of the debt securities and issuance of bonds will be used to
finance the company’s plans. On the other hand, investors buy debt securities of equity instruments in
hopes of receiving returns through interest, dividend income or appreciation in the financial asset’s price.

Common examples of Debt and Equity Instruments.

✓ Debt Instruments generally have fixed returns due to fixed interest rates.
Examples of debt instruments are as follows:
o Treasury Bonds and Treasury Bills are issued by the Philippine government. These bonds and
bills have usually low interest rates and have very low risk of default since the government
assures that these will be paid.
o Corporate Bonds are issued by publicly listed companies. These bonds usually have higher
interest rates than Treasury bonds. However, these bonds are not risk free. If the company which
issued the bonds goes bankrupt, the holder of the bonds will no longer receive any return from
their investment and even their principal investment can be wiped out.
✓ Equity Instruments generally have varied returns based on the performance of the issuing company.
Returns from equity instruments come from either dividends or stock price appreciation. The following
are types of equity instruments:
o Preferred Stock has priority over a common stock in terms of claims over the assets of a
company. This means that if a company were to be liquidated and its assets have to be
distributed, no asset will be distributed to common stockholders unless all the claims of the
preferred stockholders have been given. Moreover, preferred stockholders have also priority
over common stockholders in cash dividend declaration. Dividends to preferred stockholders are
usually in a fixed rate. No cash dividends will be given to common stockholders unless all the
dividends due to preferred stockholders are paid first. (Cayanan, 2015)
o Holders of Common Stock on the other hand are the real owners of the company. If the
company’s growth is spurring, the common stockholders will benefit on the growth. Moreover,
during a profitable period for which a company may decide to declare higher dividends,
preferred stock will receive a fixed dividend rate while common stockholders receive all the
excess.

Financial Markets

Classify Financial Markets into comparative groups:

✓ Primary vs. Secondary Markets

o To raise money, users of funds will go to a primary market to issue new securities (either debt
or equity) through a public offering or a private placement.
 The sale of new securities to the general public is referred to as a public offering and the first
o
offering of stock is called an initial public offering. The sale of new securities to one investor or
a group of investors (institutional investors) is referred to as a private placement.
o However, suppliers of funds or the holders of the securities may decide to sell the securities that
have previously been purchased. The sale of previously owned securities takes place in
secondary markets. • The Philippine Stock Exchange (PSE) is both a primary and secondary
market.
✓ Money Markets vs. Capital Markets
o Money markets are a venue wherein securities with short-term maturities (1 year or less) are
sold. They are created because some individuals, businesses, governments, and financial
institutions have temporarily idle funds that they wish to invest in a relatively safe, interest-
bearing asset. At the same time, other individuals, businesses, governments, and financial
institutions find themselves in need of seasonal or temporary financing.
o On the other hand, securities with longer-term maturities are sold in Capital markets. The key
capital market securities are bonds (long-term debt) and both common stock and preferred
stock (equity, or ownership).

Financial Institutions

Examples of financial institutions:

✓ Commercial Banks - Individuals deposit funds at commercial banks, which use the deposited funds to
provide commercial loans to firms and personal loans to individuals, and purchase debt securities
issued by firms or government agencies.
✓ Insurance Companies - Individuals purchase insurance (life, property and casualty, and health)
protection with insurance premiums. The insurance companies pool these payments and invest the
proceeds in various securities until the funds are needed to pay off claims by policyholders. Because
they often own large blocks of a firm’s stocks or bonds, they frequently attempt to influence the
management of the firm to improve the firm’s performance, and ultimately, the performance of the
securities they own.
✓ Mutual Funds - Mutual funds are owned by investment companies which enable small investors to
enjoy the benefits of investing in a diversified portfolio of securities purchased on their behalf by
professional investment managers. When mutual funds use money from investors to invest in newly
issued debt or equity securities, they finance new investment by firms. Conversely, when they invest in
debt or equity securities already held by investors, they are transferring ownership of the securities
among investors.
✓ Pension Funds - Financial institutions that receive payments from employees and invest the proceeds
on their behalf.
✓ Other financial institutions include pension funds like Government Service Insurance System (GSIS)
and Social Security System (SSS), unit investment trust fund (UITF), investment banks, and credit unions,
among others.