Business Finance

Module 2
Flow of funds (FOF) are financial accounts that are used to track the net inflows
and outflows of money to and from various sectors of a national economy.
Macroeconomic data from flow of funds accounts are collected and analyzed by a
country's central bank.

In your previous Lesson, you have learned on the different types of Financial
Institution, Financial Instrument and Financial Market which plays an important role
in the Flow of funds.

Jumpstart

For you to understand the lesson well, do the following activities. Have fun and
good luck!

Activity: Read and explain the following case questions: Use separate sheet of paper
for your answers.

1. Suppose that you run a business and during your management of money, some
cash remain. What should you do with that cash?
2. If you’re going to save your money, where would you keep it?
3. Given the opportunity to manage a business, what would it be? Now, suppose that
the business that you’ve manage became profitable for some time. Then you decided
to expand your business but you don’t have enough cash to pay for the expansion.
Where can you get the additional funding?

Discover
Draw two boxes and label with names of learners A and B. Below [A], write “Saver”,
and below [B], write “users of funds”.
If A knows that B is in need of funds, or if B knows that A is willing to invest funds, A
and B may agree to make a Private Placement.
*Private Placements - the sale of a new security directly to an investor or group of
investors.

However, if these facts are unknown to them, A and B can go to a Financial Market
which is an organized forum that lets A, along with other suppliers of funds, and B,
along with other users of funds, meet and make transactions. Once A and B have met
in the Financial Market, they can now agree to make a private placement. If A and B do
not want to make an effort to find a counterpart in the Financial Markets, A and B may
go to a Financial Institution. A Financial Institution will receive A’s supply of funds and
match it with B’s demand of funds. Unlike the Financial Markets were A and B knows
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to whom the fund went and from whom the funds came, Financial Institutions serve as
an intermediary to the suppliers and users of funds.
Moreover, Financial institutions actively participate in the financial markets as both
suppliers and users of funds.

Financial System:

Financial Institution

[Learner A] [Learner B]
Savers/Suppliers of Private Placement Users/Demanders
Funds of Funds

Financial Markets

Flow of funds
Flow of securities/notes/bonds/debt instruments
Figure 1: The Financial System

*Note that on the diagram presented, the solid lines represent the flow of cash/funds,
while the colored lines represent the flow of financial instruments which represent
obligations to transfer cash or other assets in the future.

Explore

Here are some enrichment activities for you to work on to master and strengthen
the basic concepts you have learned from this lesson.

Enrichment Activity: Read and answer the following questions. Use separate sheet
of paper for your answers.

1. How transactions between suppliers and users of funds take place. How would
you prove that there was a transaction so that the demander will be able to
repay the supplier on time and at the right amount?
2. Due to the increased need for security for the performance of obligations arising
from these transactions and due to the growing size of the financial system,
where does the transfers of funds from one party to another are made?

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 Great job! You have understood the lesson. Are you now ready
to summarize?

Deepen

At this point, we will further discuss the composition of the Financial System and
that you will identify the types of Financial Markets, Financial Institutions and
Financial Instruments.

1. 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.
• Recall from ABM the following definitions:
- 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

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.

• Identify 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:

•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.

•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

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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:

•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, 2017)

• 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.

2. Financial Markets
• Recall the definition of financial markets from earlier discussion.
• Classify Financial Markets into comparative groups:

- Primary vs. Secondary Markets

• 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 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.
• 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

•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.
• 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).

3. Financial Institutions
• Recall the definition of Financial institutions from the earlier discussion.
• Identify 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
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 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.
Figure 2: How Financial Institutions Provide Financing for Firms (Gitman &

Zutter, 2012)

• The figure above illustrates how the key financial institutions serve as
intermediaries for suppliers and users of funds Integration of Learning
• Question for reflection: How would you relate the role of financial managers, role of
financial markets and role of investors?

Role of Financial Role of Financial Role of Investors

Managers Markets

Financial managers The financial markets Investors provide the

make financing provide a forum in which funds that are to be
decisions that require firms can issue used by financial
funding from investors securities to obtain the managers to finance
in the financial funds that they need and corporate growth.
markets. in which investors can
purchase securities to
invest their funds.

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 Gauge
Directions: Read carefully each item. Use separate sheet of paper for your answers.
Write only the letter of the best answer for each test items.

1. This is one of the financial intermediary handling individual savings. It receives

premium payments that are placed in loans or investments to accumulate funds to
cover future benefits.
A. life insurance company C. savings bank
B. commercial bank D. credit union

2. Which of the following is not a financial institution?

A. A newspaper publisher C. An insurance company
B. A pension fund D. A commercial bank

3. What is the type of financial intermediary that pools savings of individuals and
makes them available to business and government users? Funds are obtained through
the sale of shares.
A. savings and loans C. savings bank
B. mutual fund D. credit union

4. Most businesses raise money by selling their securities in a.

A. a direct placement C. a private placement
B. a stock exchange D. a public offering

5. Which of the following is not a service provided by financial institutions?

A. Investing customers’ savings in stocks and bonds
B. Paying savers’ interest on deposited funds
C. Buying the businesses of customers
D. Lending money to customers

6. Government usually:
A. maintains permanent deposits with financial institutions.
B. borrows funds directly from financial institutions.
C. is a net demander of funds.
D. is a net supplier of funds.

7. By definition, the money market involves the buying and selling of:
A. funds that mature in more than one year
B. stocks and bonds
C. short-term funds
D. flows of funds

8. Which of the following is created by a financial relationship between suppliers

and users of short-term funds?
A. financial market C. capital market
B. money market D. stock market

9. Firms that require funds from external sources can obtain them from:
A. private placement C. financial institutions
B. financial markets D. All of the above

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10. The major securities traded in the capital markets are:
A. treasury bills and certificates of deposit
B. commercial paper and Treasury bills
C. bonds and commercial paper
D. stocks and bonds

11. Which of the following actively participate in the financial markets as both
suppliers and users of funds?
A. private placements C. financial instruments
B. flow of funds D. financial institution

12. Long-term debt instruments used by both government and business are known as:
A. equitiesC. stocks
B. bonds D. bills

13. Which of the following is NOT an example of financial institution?

A. Commercial banks C. Insurance companies
B. Corporate bonds D. Mutual funds

14. It is generally have fixed returns due to fixed interest rates.

A. debt instruments C. equity instruments
B. corporate bonds D. treasury bonds

15. Which of the following role that provide funds to be used by financial managers to
finance corporate growth?
A. Financial market C. Financial intermediaries
B. Investors D. Suppliers