Business Finance

Fundamental Concepts and Tools

of Business Finance

Jose O. Berroya, Jr., BSME, MBM

 Finance

Definition:

Finance may be defined as the study of the

acquisition and investment of cash for the
purpose of enhancing value and wealth.
 Categories of Finance

Finance, in general, is divided into categories

according to the type of entity or organization
served.

1. Public Finance

2. Private Finance.
 Public Finance

Public finance is that category of general

finance, which deals with the revenue and
expenditure patterns of the government and
their various effects on the economy.
 Private Finance

This category deals with the area of general

finance not classified under public finance.

1. Personal Finance
2. Finance of Non-profit Organizations
3. Business Finance.
 Personal Finance

Concerned with the fundamentals of managing

one’s own personal money affairs.

Finance of Non-Profit Organizations

Includes private undertakings such as charity,

religion, and some private educational
institutions.
 Business Finance

• Refers to provision of money for commercial

use
• Concerns effective use of funds
• Covers the financial management of private
profit-seeking concerns in the business of
service, trade, manufacturing, mining, public
utilities, financing, etc.
• Procurement and administration of funds
with the view of achieving the objectives of
the business.
 Categories of Business Finance

1. Small business finance

2. Corporation finance

3. Multinational business finance.

 The Goals of Business Finance

1. Maximizing profit
2. Maximizing profitability
3. Maximizing profit subject to cash constraints
4. Maximizing net present worth, and
5. Seeking an optimum position along a risk-
return frontier.
 1. Maximizing Profit

Maximizing profit means realizing the highest possible

peso or dollar income. A firm, for instance, may seek to
double its peso or dollar income for the current year.
This framework, however, is not very useful in making
sound financial decision. The amount of profit earned
by the firm is not adequate to evaluate its performance.
For instance, the net income of XYZ company for a
certain year in the amount of Php480M does not provide
much useful information for the investor or financial
manager. This is true even if the same amount
represents an increase from previous year’s profit of the
firm.
 2. Maximizing Profitability

When a firm decides on obtaining a higher rate

of return on its investment, it is said to be
maximizing profitability. The following data
show an improvement in the company’s
performance:
Mikaela Company
(2006)
2005 2006
Net worth (PhP) 100,000,000.00 200,000,000.00
Net profit (PhP) 10,000,000.00 50,000,000.00
Rate of return on investment 10% 25%
 3. Maximizing Profit Subject to Cash
Constraint

In the quest for profit maximization, undue

emphasis is sometimes placed on cash balance.
Maintaining too large a cash balance reduces the
chance of a favorable rate of return, while running
out of cash when needed is disastrous. The ideal
set-up is to maximize profits, while at the same
time maintaining a cash balance that can take care
of cash requirements anytime. This condition is
especially critical in the operation of banks.
 4. Maximizing Net Present Worth

Under the net present worth concept, the objective

of the firm 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. Present values may be better understood
by way of knowing the concept of the time value of
money.
 Time Value of Money

This concept 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. Thus, to be able to find
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.
 Calculation of Present Worth

The present worth of a value to be received in the

future is illustrated as follows:

Question: What is the value today of

Php100,000.00 to be received next year assuming
that the prevailing rate of interest is 10% p.a.?

PV = FV / (1 + rate of interest) = Php100,000.00 / 1.10 =

Php90,909.09
 5. Seeking an Optimum Position Along a
Risk-Return Frontier

A firm can set a goal of achieving the best

possible combination of risk and return. A
little more risk may be accepted, for instance,
for an expected additional rate of return.
 Return on Investment or Net Worth

The net income generated by the use of

investments or the net worth of a firm is
referred to as return on investment.

When it is expressed in percentage, it is

called rate of return.
 Risk

Uncertainty as to loss is called risk. When

used in finance, the term applies to the
potential incurrence of loss of money or its
equivalent.
 Calculation of Expected Value Using Risk and
Return Factors

The optimum position of risk and return may be

determined by calculating the expected value of
alternative decisions. The expected value of a
return on investment is equal to the return
multiplied by the percentage of probability that it will
happen (called the risk factor).
Return on Net Worth Expected Value
Option (PhP) Probability (PhP)
(A) (B) (A x B)
1 100,000,000.00 60% 60,000,000.00
2 200,000,000.00 50% 100,000,000.00 (optimum position)
3 300,000,000.00 30% 90,000,000.00
 Financial Statements

Financial statements are those that present

financial information to various interested
parties. Inasmuch as the finance manager is
responsible for managing the financial activities
of the firm, he is naturally one of the most
concerned about getting relevant information
through the use of financial statements.
Assets = Liabilities + Equity
► Most important equation in business

► So, what does it mean? It means you can get

assets through liabilities or equity.

► So, what does that mean? That means you can

get assets (like cash, factories or land) through
taking on debt (loans from the bank, issuing
bonds) or equity (relinquishing partial ownership
interest in your company)
What Exactly are Assets?
► Simplified Definition of an Asset: Cash or anything that will produce cash in
the future.

► More exact definition: is anything owned by an individual or a business, which

has commercial or exchange value. Assets may consist of specific property or
claims against others, in contrast to obligations due others.

► Exact definition: Probable future economic benefits obtained or controlled by

a particular entity as a result of past transactions or events.

► Let’s keep it simple!

► For instance, if you had a factory that made computers, then it would be
considered an asset.
► Why? Because the factory would produce computers that would be
sold in the market for cash.

► Examples of assets include: cash, machinery, inventory, factory, land, or

anything else that will produce cash in the future.
What are Liabilities?
► Simplified definition of liabilities: Anything that will reduce an asset (such as
cash) in the future.

► More exact definition: a loan, expense, or any other form of claim on the
assets of an entity that must be paid or otherwise honored by that entity.

► Exact definition: Probable future sacrifices of economic benefits arising from

present obligations of a particular entity to transfer assets or provide services to
other entities in the future as a result of past transactions or events.

► Let’s keep it simple!

► For instance, if you owe your suppliers money for inventory then you would
need to pay them at some point. Thus, you have liability until cash (an asset)
was used to payoff the money owed.

► Example of liabilities include: accounts payable, loans outstanding, and

unearned services (occurs when you receive cash before performing your
service)
What is Equity?
► Simplified definition of Equity: The value of your company after you payoff
all the money you owe.

► More exact definition: ownership or percentage of ownership in a company or

items of value.

► Exact definition: Residual interest in the assets of an entity that remains after
deducting its liabilities. In a business enterprise, the equity is the ownership
interest.

► Let’s keep it simple!

► For instance, you have a truck worth $20,000 (an asset), a factory worth
$140,000 (an asset) and $30,000 of cash in the bank (an asset). If you sold
the truck and the factory you would have $190,000 in cash and that would be
your equity. However, you owe the bank $80,000 because you bought the
car and part of the factory on a loan. Thus, your equity after paying off your
loan (liabilities), would only be $110,000.

► Examples of equity include common stock or simply one’s ownership of a

private company (e.g. I own 28% of Mike’s Hard Lemonade Stand, while my
other partners own the other 72%).
Financial Statements
► There are 3 financial statements you
must know:
► Balance Sheet

► Income Statement

► Cash Flow Statement.

Balance Sheet
► Elements of the balance sheet?
► Assets, Liabilities, and Equity

► The balance sheet is where you find out how much cash you have and
how much your truck and factory is worth.

► The balance sheet shows a company at a moment in time (e.g. December

31, 2000).
► It is like taking a snapshot of the company at a split second and
recording the financial position the company is in. You would count
every truck and add up every bank account to come up with a value
of your assets. You would then calculate how much money you
owed and subtract that from your assets to determine your equity
(Also known as “net assets”).
Balance Sheet Example
► The balance sheet for the company we examined earlier would be
the following: Balance Sheet
31-Dec-00

Assets Liabilities
Cash $30,000 Bank Loan $80,000
Truck $20,000 Equity
Factory $140,000 My investment $110,000

Total Assets $190,000 Liabilities & Equity $190,000

► Note that my debt is $80,000 and my equity is $110,000. This is

because I bought the factory and the truck with a combination of
my money (equity) and the bank’s loan (liability). In other words, I
invested $110,000 of my money and $80,000 of the bank’s money to
buy a truck and a factory and maintain a cash balance in the bank of
$30,000.
Income Statement
► The income statement presents the results of a company’s operations
over a period of time.

► The balance sheet and the income statement are linked and it is key that
you understand this.

► Think of the balance sheet as your cumulative GPA and think of each
semester GWA as your income statement. Your cumulative GPA is
affected by each semester and shows the net affect of all your efforts.
Your semester GWA is earned over a specific period of time and
refreshes each semester.

► The results of operations, as indicated in the income statement gets put

into the balance sheet, similar to how each semester’s GWA get put into
your cumulative GPA.
Income Statement
► The income statement consists of revenues and expenses.
► By subtracting expenses from revenues you arrive at net
income.
► Revenue is defined as inflows or other enhancements.
► Examples of revenue for a clothes company would be
when they sell a shirt for $45.
► When this company sells this shirt it can then book $45 as
revenue. Note it would not book $45 as net income because the
costs of producing the shirt, designing the shirt, and selling the
shirt have not been considered
Income Statement
► Net Income = Revenues – Expenses
► A company makes a profit (net income) only if its
revenues are greater than its costs.
► For example, if the $45 shirt cost a total of $63 to
make and there were no other revenues or
expenses then the net loss would be $18.
Income Statement
► A simplified income statement is shown below:
Income Statement
1-Jan-00 to 31-Dec-00

Revenues
Shirts 45

Expenses
Shirt Design Cost 20
Employee Costs 32
Production Costs 11
Total Costs 63

Net Income (loss) ($18.00)

The Major Link
► The Balance Sheet has an account under the Equity section called
Retained Earnings.

► The Retained Earnings account accumulates all the net incomes or net
losses that occur in every Income Statement.

► The balance of retained earnings gives a total amount of money earned

or lost since the business was created.

► Hence, the balance in the Retained Earnings account is a good place to

look to see if your company has destroyed or created value since its
beginning. Companies like GE will have huge amounts of Retained
Earnings, while newer companies will often have a negative balance in
Retained Earnings.
Statement of Cash Flows
► Does net income of $500 equal a gain of $500 in cash?
► Absolutely NOT!!!!!
► Cash flow and net income are completely different
animals.
► Remember the $45 shirt…if I had bought that shirt with
cash then the net loss would be $18 and the cash lost
would be $18. However, what if I bought the shirt on
credit.
► In this case, the net loss would remain the same because the
revenue would still be counted since a sale was made, however the
cash flow would differ because no cash was exchanged.
Statement of Cash Flows
► The statement of cash flows shows the actual cash
inflows and outflows.
► It shows cash inflows and outflows in 3 categories
► Cash Flows from Operations
► Cash Flows from Investing Activities
► Cash Flows from Financing Activities
Cash Flow Statement
► Typically, a healthy growing company that is making a
profit will show a positive Cash Flow from Operations
because it is making a profit.

► A negative Cash Flow from Investing Activities will most

likely been seen for a growing company because the firm is
investing in projects to grow.

► The cash flow from financing will most likely be positive

as it will need external capital to continue its growth.
Cash Flow Statement
► An example of a simplified Statement of Cash Flows

Simplified Statement of Cash Flows

Cash Flow from Operating Activities 400

Cash Flow from Investing Activities -300
Cash Flow from Financing Activities 500
Total Change in Cash 600
Beginning Balance of Cash 200
Ending Balance of Cash 800
 Budget

• An estimate of income and expenditures for a

future period.
• Contrasted with the income statement, which
is a summary of the performance of the firm for
the past period, and with the balance sheet
which presents the financial condition of the
firm at a given date, past or present, the
budget completes the financial picture by
referring to the future.
• Budgets are essential elements in the planning
and control of the financial affairs of the
business.
• Large corporations place so much emphasis in
the annual budget which is normally broken
down into monthly and weekly periods, and
which may take several months to prepare.
• In preparing the budget, an estimate of sales
and income for the period is made, followed by
estimates of expenditures in purchasing,
administration, production, distribution, and
research.
• Detailed budgets for cash flow and capital
expenditures are also included.
 Sales Budget

• The sales budget is the starting point of

company budgets.

• It shows an estimate of sales in units and

dollars or pesos for each major subdivision
of sales.
 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.
 Production Budget

• The production budget is an estimate of the

quantity of products that should be
produced in accordance with the sales
budget.

• It also shows the monthly breakdown of

quantities to be produced for each product
depending upon the firm’s seasonal sales
index.
 Significance of Financial Statements and
Budgets

• There are five (5) distinct groups interested in

knowing the financial standing of the firm:
1. Owners
2. Management
3. Creditors
4. Government
5. Prospective Investors.
• In some cases, customers, employees, and
prospective employees require financial data
about the firm. Financial statements and
budgets provide most of these information.
 Owners

• The owners are primarily concerned with

receiving information on the anticipated
financial benefits that will be generated by
the firm.

• They also need to know whether it is wise

or not to continue their relationship with the
firm as owners.
 Management

• Management is concerned with effective

planning and control of the activities of the
firm.
• As various financial information are
provided by the financial statements and
budgets, they are particularly useful to
management in:
o Anticipating asset needs
o Planning for necessary financing, and
o Establishing standards by which to test
current operating performance.
 Creditors

• Creditors will be interested to know if the

firm is credit-worthy.

• The use of the firm’s financial statements

and budgets will help them find out the
answer.
 Government

• Financial statements are required by the

government for tax and regulatory
purposes.

• Examples of areas of concern are income

tax assessment and the regulation of the
issuance of securities like stocks and
bonds.
 Prospective Investors

• Prospective investors are mainly interested

in the protection of their investments and
the earnings they require over a period of
years.

• The balance sheet and the income

statement will be very useful in this regard.
 Customers

• Customers who would want to establish

long-term relationship with the firm would be
particularly interested to know how stable
the company is.

Employees

• Employees who would want to consider

long-term employment with the firm would
also want to know the long-term prospects
of the firm.
Thank You!