FINANCE

• The word finance is derived from the Latin word finer, meaning “to end” or “to pay”. When a person
pays his bill, the financial matter is ended.
• According to Saldana (1997), finance is the efficient allocation of scarce resources.
• He also added that it concerned with the acquisition of the needed funds.
• Medina (2007) defined finance as the study of the acquisition and investment of cash for the purpose of
enhancing value and wealth.

PRIMARY GOALS
The primary goals of business concern must therefore be as follows:
1. To earn profit – Funds are invested in a business to earn sufficient return on investment.
 Earning per Share (EPS) refers to how much net income is earned for every share of capital stock
outstanding.
EPS = Net Income Related to Common Stock/Weighted average number of shared outstanding of common
stock.

2. Increasing the value of business – Growth and stability are the primary bases in measuring the value of a
business entity.

3. Social Responsibility of Businessmen – It refers to his contribution to the improvement of the quality of life
in the community.

CONCEPTS AND FUNCTIONS OF BUSINESS

FINANCE

The following are the functions of Business Finance:

1. Allocation of Financial Resources

2. Procurement of Funds

3. Efficient and Effective Utilization of Financial Resources

ALLOCATION OF FINANCIAL RESOURCES

  The objective is to be assured that funds are channelled to activities that are considered profitable
and / or will increase the value of the business itself and that company costs and risks are minimized.

 The more risky a project is, the higher is the standard set as minimum desired rate of return on
investment.

 Risks maybe in the form of possible losses arising from decline in revenue, rise in operating costs and
expenses, and decline in property value.

PROCUREMENT OF FUNDS

Capital -must be made available at the least cost when it is needed. The procurement function requires
awareness of the different sources of funds and the costs involved.

Cost of capital varies with the sources thereof.

On borrowed funds, it is in the form of financing charges (interest, commissions and service –
charges).
On capital contributed by owners or stockholders, the corresponding cost is in the form of dividends
or shares in profit.

EFFICIENT AND EFFECTIVE UTILIZATION

OF FINANCIAL RESOURCES
Efficient Utilization of financial resources refers to their economical use. Inefficiency in the use of financial
resources may be caused by extravagance in the choice of property and equipment, unnecessary expenditures,
tardiness of personnel and non-productive resources.

Effective Utilization of financial resources refers to their use towards attainment of predetermined
objectives. This requires a periodic review of operations to determine whether they are in accordance with plans
and whether the plan, as prepared will enable the company to attain its short – term goals and long- term
objectives considering the changes in the economic environment.

CLASSIFICATION OF FINANCE
As to form of Negotiation
1. Direct Finance
 Is finance involved in direct borrowing.
 The security acquired (called direct security) by the surplus and (lender) is the same security issued by
the deficit unit (borrower).
 It involves lending to ultimate borrowers

2. Indirect Finance
 It involves financial intermediaries in the real sense of the word. This means that financial
intermediaries act as middlemen then they buy securities for resale or simply facilitate the sale from the
original issuers to the final buyers.
 The transaction that happens when deficit units borrow with the use of financial intermediaries

As to User
1. Public Finance
 Deals with the revenue and expenditure patterns of the government
 It is concerned with government affairs – managing the government’s like building streets, bridges,
among others and payment of government employees are government spending and thus public finance.
 Government spending and government borrowing

2. Private Finance
 All finance other than public finance.
 Deals with the area of general finance not classified under public finance

Private Finance
Private finance were divided among:

1. Personal Finance
 It refers to finance conducted by individuals/consumers.
 A family spending for their food, clothing, shelter, recreation, education is personal finance.
 A father giving his son allowance
 A sister borrowing money from another sister
 An aunt supporting her niece in her studies

 Individuals borrowing from financial institutions and depositing money in the bank.
 Classification of Private Finance

2. Finance of Non – profit Organization

 Involves those conducted by charitable, civic, religious among others.
 Not for profit as they do not aim to gain profit or increase wealth.
 Charitable purposes like thrift stores, religious purposes like the Catholic Church, for civic purposes like
the Rotary Club.
 They spend for their operations and buy long – term assets and invest any extra money that they have.
 Everything that they do that involves funding is finance of non – profit organization.
 Classification of Private Finance

3. Business Finance
 Deals with financing for business firms or for commercial use, the goal of which is to make profit.
 Businesses either produce goods and services for sale or buy goods and sells the same.
  Where to obtain capital for a particular company and where to use it
 A company that buys the stocks or another company because it has excess funds or borrows money from
the bank to buy land, building or equipment.
 The funds are used to earn profit and increase the value of the firm and the wealth of the owners.
- End of Lesson I –

Three interrelated areas of Finance:

1. Managerial Finance
2. Investment
- Focus on decisions of individuals, financial institutions and non – financial institutions as they choose
where to place excess funds. These are the assets of the people or entities holding / owning them.
3. Money and Capital Markets
- It deals with the different financial instruments.

FINANCIAL MANAGEMENT
Otherwise called managerial finance

 It is concerned with the management of funds

 It is the efficient and effective allocation, acquisition, and utilization of funds.

 It is concerned with the maintenance and creation of economic value or wealth.

THE FINANCIAL MANAGER: HIS PRIMARY

ACTIVITIES
Financial manager must concern with different items included in the balance sheet.

1. Financial Planning and Analysis

2. Managing the Assets of the Company
3. Managing the Company’s Liabilities and Owner’s Equity

Financial Planning and Analysis

 The financial manager takes part in corporate, strategic and operational planning in an enterprise.
 He must have knowledge in economics in order to make projection based on accumulated data and the
different options open to management.

Managing the Assets of the Company

 Examples of assets are cash, marketable securities, receivable, inventories, plan, property and equipment.
 The financial manager determines the mix and type of assets a business must have and sees to it that they
are duly accounted for.

Managing the Company’s Liabilities and Owner’s Equity

 The financial manager determines the mix of short – term and long – term financing, what particular source
is best at a given point in time, and the level at which the debt/equity ratio should be maintained.
 These are very important because they will affect profitability and liquidity of the business.

FINANCIAL DECISION MAKING

The financial manager must have proficiency in managerial economics
 For short – term financial decisions, the financial manager gives more emphasis on items that are
affected by current operations such as current assets, current liabilities, working capital, current
ratio, net income and variances between budgeted and actual results of operations.

 For long – term financial emphasis must be on items that reflect the long – term nature thereof such
as fixed assets, long – term debt and owners equity.

GOALS OF THE FINANCIAL MANAGER

Among these goals are:
• Acquisition of funds with the least cost from the right sources at the right time
• Effective cash management
• Effective working capital
• Effective inventory management
• Effective investment decisions
• Proper asset selection
• Proper risk management

THE FINANCIAL MARKETS

• These are the institutions and systems that facilitate transactions in all types of financial claims
• They are the bridge between those with excess funds and those who need funds
• It is the heart of the financial system, identifying the volume of credit available, attracting savings and
setting interest rates and security prices (Rose 1994).

CLASSIFICATION OF FINANCIAL MARKETS

The financial markets are divided into:
1. As to term of maturity 2. As to type of issue
• Money market • Primary market
• Capital market • Secondary market

As to term of maturity
A. Money Market

 It covers markets for short – term debt instruments (maturity of one year or less)
 These securities include Treasury Bills issued by the government, bankers’ acceptances, negotiable
certificates of deposits and commercial papers.
 Being short – term, these securities are at low risk of interest rate changes.

B. Capital Market

 These are markets for long – term securities (maturity of more than a year)
 These instruments often carry greater default and markets risks than money market instruments
 The need for long – term assets as purchase of land or building or plant expansion will resource to the
capital market as a source of funds.

As to type of issue
A. Primary Market

 Consists of underwrites, issue, and instruments

 The primary market transaction involves either equity (stocks) or debt securities (bonds).
 Most primary market transactions are done through investment banks, also called merchant banks, which
help the corporations issuing stocks or bonds sell these stocks or bonds to interested investors.

B. Secondary Market

 These are markets for currently outstanding securities

 These securities were previously bought and owned and now being resold by these initial investors
 Secondary market transactions do not affect the total outstanding financial assets in the economy.
 Their role is to assure that a holder can sell his security at any time.

FINANCIAL
INSTITUTIONS/INTERMEDIARIES
• These are the firms that bridge the gap between the investors and borrowers which issue their own financial
instruments called secondary instruments.
• They channel the funds from the lenders to the borrowers

• When they underwrite securities or acts as brokers or dealers, they are intermediaries.

• If they buy securities, they are investors or lenders and when they are the one issuing the securities, they
are borrowers.

• Financial intermediaries have brought into existence several of the financial products or securities now
available in the financial markets.

CLASSIFICATION OF FINANCIAL
INTERMEDIARIES
Two basic categories:
A. Depository Institutions
1. Commercial Banks

• Ordinary Commercial banks

• Expanded commercial or universal banks

2. Thrift Banks
• Savings and Mortgage banks
• Private development banks
• Savings and loan associations
• Microfinance thrift banks
• Credit unions
3. Rural Banks

B. Non - Depository Institutions

1. Insurance companies
• Life insurance companies
• Property/casualty insurance companies
2. Fund Managers
3. Investment banks/houses/companies
4. Finance companies
5. Securities dealers and brokers
6. Pawnshops
7. Trust companies and departments
8. Lending investors

A. Depository Institution
- Refers to financial institutions that accepts deposits from surplus units (investors).
- It issues checking or current account, savings and the time deposit and help depositors with money market
placement.
- It cannot be withdrawn without penalty prior to maturity, but it earns more interest than the savings
account.

EXAMPLE
1. Commercial Banks - they grant only short – term loans. These loans were originally extended to
merchants for the transport of their goods in both domestic and international markets.

a) Ordinary commercial banks perform the more simple functions of accepting deposits and granting
loans but they do not do investment functions.

b) Expanded commercial banks or universal banks (unibank) perform investment services. They offer
the widest variety of banking services among financial institutions.

2. Thrift Banks - thrift banking system is composed of savings and mortgage banks, private development
banks, stock savings and loan associations, and microfinance thrift banks. Thrift banks are engaged in
accumulating savings of depositors and investing them.

a. Savings and mortgage banks are banks specialized in granting mortgage loans other than the basic
function of accepting deposits.

b. Private development banks cater the needs of agriculture and industry providing them with
reasonable rate loans for medium and long – term purposes.

c. savings and loan associations (SLAa, S&Ls) accumulate savings of their depositors/stockholders and
use these accumulated savings, together with their capital for the loans that they grant and for investments
in government and private securities.

d. microfinance thrift banks are small thrift banks that cater to small, micro and cottage industries,
hence, the term “micro”.

e. Credit unions are cooperatives organized by people from the same organization like farmers,
fishermen, teachers, sailors, and of one company, among others.

3. Rural Banks and Cooperative Banks - these are the more popular type of bank on the rural
communities. Their role is to promote and expand the rural economy in an orderly and effective manner by
providing people in the rural communities with basic financial services.

B. Non - Depository Institutions

- Non – depository institutions such as pension funds, life insurance companies, mutual funds, and finance
companies like depository institutions also perform financial intermediation.

1. Insurance Companies
 a. Life insurance companies are financial intermediaries that sell life insurance policies. Policyholders
pay regular insurance premiums.

b. Property / Casualty Insurance Companies offer protection against pure risk. They insure against
injury or property loss resulting from accidents, work – related injuries, malpractice, natural calamities,
etc. Casualty insurance covers the individual (disability insurance).

2. Fund Managers - included among fund managers are pension fund companies and mutual fund companies.

- Pension fund companies

- Mutual fund companies
- Open – end investment companies

3. Investment Banks/Houses/Companies - Investment companies are financial intermediaries that pool

relatively small amounts of investors’ money to finance large portfolios of investments that justify the cost of
professional management. Investment banks underwrite new issues of equity and debt securities.

4. Finance Companies - are profit - oriented financial institutions that lend funds to households and businesses.
They are not issuing checking or savings account and time deposits. These companies are grouped into three;
sales, consumer and commercial.

5. Securities Brokers and Dealers – Securities brokers are only compensated by means of commission while
securities dealers buy securities and resell them and make profit from it.

6. Pawnshops – are agencies where people and small businesses “pawn” their assets in exchange if an amount
much smaller than the value of the asset or use their asset as collateral for loan.

7. Trust Companies / Departments – a corporation organized for the purpose of accepting and executing trusts
and acting as trustee under wills, as executor, or as guardian.

8. Lending Investors – individuals or companies who loan funds to borrowers, generally consumers or
households.

C. Non – Financial Institutions

- These are the businesses other than the financial institutions or intermediaries.
- They include trading, manufacturing, extractive industries, construction, genetic industries, and all firms other
than the financial ones.
- When they buy securities they are lenders, when they issue securities they are the borrowers.

- End of Lesson II -
Financial Statements
- are the products of the financial accounting. They show the result of operation, financial condition, changes in
owners’ equity and sources and uses of cash.
BASIC FINANCIAL STATEMENT
Below are the basic financial statements:
• Income Statement or Statement of Profit or Loss
• Balance Sheet or the Statement of Financial Position
• Statement of Changes in Owners’ Equity
• Cash Flow Statement or Statement of Cash Flows

Income Statement
- It is now called Statement of Comprehensive Income
- It shows the result of operations of the company
- It also shows the profitability of the firm.
- It covers a certain accounting period, a month, a quarter, a six – month period or a year.

Product Costs vs. Period Costs

Product Costs – these are the costs of direct materials, direct labor, and overhead. It is also called
manufacturing costs.

• Direct materials and direct labor are variable costs or costs that change in volume.

Period Costs – refers to costs incurred during a particular time period and reported either as selling or
marketing expenses and administrative or general expenses.

• Part of period costs are the taxes paid to the government including income tax for the period.

Balance Sheet
- It is now called Statement of financial condition or sometimes statement of financial position.
- It shows the assets, liabilities and owners’ equity of the business.
- It also shows the financial condition or position of the business.
- It shows the liquidity and solvency of the firm.

Market Value vs. Book Value

Book value –a term used when the amount shows in the traditional financial statement is the acquisition costs
less any allowance for bad debts or accumulated depreciation.

Market value – these are the current replacement costs like for example the values that assets will command in
the open market. Most assets are valued at historical or acquisition costs.

Statement of Changes in Owners’ Equity

- details the changes that occurred in the owner (s) equity. It shows the additional investment of a sole
proprietorship or partnership and additional issuances of corporate stocks for corporation.

- It shows the beginning owner(s) equity with additional investments for a sole proprietorship or partnership
or for a corporation, additional issuances of corporate stock.

- It also shows the withdrawals made by sole proprietorship or partner(s) or declaration of dividends of a
corporation.

- It shows profit of the retained earnings if a separate statement is not made.

Statement of Retained Earnings

- details the beginning retained earnings, the profit loss of the corporation, dividends declared, retained
earnings appropriated and return of appropriation of retained earnings.

Statement of Changes in Stockholders’ Equity

- After preparing the retained earnings, the statement of changes in stockholders equity is made. It starts
with the capital stock of the corporation.

Cash Flow Statement

- sometimes called the funds flow statement or the statement of the sources and assets or the statement of
sources and users of funds

- The cash flow statement is important to provide additional information as to the cash position, which is an
indication of the liquidity of the firm.

- It can be a simple cash flow statement of cash receipt and cash disbursements as is done in very small
businesses.

This statement is divided into three sections

1. Net cash flow from operating activities – are all operation – related earnings activities of the company –
rendering services for a service firm, selling goods for a trading concern, and manufacturing and selling
activities for a manufacturing company.

2. Net cash flow from investing activities – involves all activities related to non – current assets – disposing
them or selling and buying them.

3. Net cash flow from financing activities – involve obtaining resources from owners (issuances of capital
stocks) and paying them dividends as their share in the profit of the company.
FINANCIAL ANALYSIS: TOOLS AND
TECHNIQUES
Financial Analysis
- refers to examination of financial data of an entity to determine its profitability, growth, solvency, stability and
effectiveness to its management. Relationships between financial data are interpreted and their significances are
used as guide in the decision making process.

Financing Decisions
- refers to decisions that involve funding investments and operations over the long run.
Steps in analyzing the financial statements
1. Understanding the information provided in the financial statements.

2. Drawing logical conclusion based on the data presented.

3. Making the appropriate decision on the course of action to take.

For Short – term Decision Making

A. Analysis of Financial Statements
1. Horizontal Analysis: Two or more sets of financial statements are used:
• Comparative Statements
• Trend Ratio
• Gross Profit Variation analysis
• Analysis of Change in net income
2. Vertical Analysis: Only one set of financial statement is used.
• Common size statement
• Financial Ratios
B. Working capital and cash flow analysis
C. Cost – volume - profit (or breakeven point) analysis

For Long – term Decision Making

• Payback period
• Discounted cash flow (DCP) methods:
• Internal rate of return
• Discounted payback period
• Net present value
• Probability index

Limitations of Financial Statements

• Variations in application of accounting principles
• Financial statements are interim in nature although they give an impression of being accurate
• Financial statements do not reflect changes in the purchasing power of the monetary unit.
• Financial statements do not contain all the significant facts about a business.
STANDARDS IN FINANCIAL STATEMENT
ANALYSIS
Horizontal Analysis
Analysis of financial statements can be done comparatively to show performance and financial condition
in prior years as compared to the current years. This reveals if the profitability and the financial conditions of
the firm are improving or not. Trend analysis involves analysis of significant changes in absolute amounts and
percentages, including changes in the ratios used in ratio analysis.

Value in new time period – value in old time period

x 100 = % change
Value in old time period

• Comparative Statements show the increase or decrease in account balances and their corresponding
percentages.

• Trend Ratios. Comparative statements are often supplemented by trend ratios or percentages showing
the behavior of financial data for successive periods.

Vertical Analysis

It is the process of analyzing the entries on a financial statement, in relation to the industry standard. For
example, a vertical analysis of a balance sheet would describe each asset as a percent of total assets.

Ratio Analysis is descriptive; it describes the situation that exists. It is not prescriptive; it does not tell the
manager what to do. However, if the manager has the ability to look for the past calculation and see the trends,
decision making becomes easier.

FINANCIAL RATIOS
• Primary ratio considers profit or return level of the business entity, normally for the year, in relation
to the capital employed or invested, or net assets during the same period.
• Secondary ratios are further investigation of primary ration. These are ratios concern with
profitability – profit relation to sales; and the other is with activity – sales in relation to capital
employed or net assets.
• Tertiary ratios evaluate profitability of the business and analysis of activity.
• Financial status ratios are those that help analyze a business financial standing in terms of its ability
to pay liabilities and settle obligations.
• Solvency ratios calculate the ability of the business to meet the interest due from the profits available.
• Investment ratios are intended to give investors financial position of the capital and the invested
capital.
Commonly Calculated Ratios
• Liquidity Ratios • Leverage Ratios

• Activity Ratios • Profitability Ratios

Liquidity Ratios
Liquidity is the ability of the assets to be converted quickly into cash. It is assumed that the firm’s
inventory will be converted to cash during the course of a year so that the receipts from inventory can be used to
service the current debt.

• Current Ratio firm’s ability to meet short – term obligations

Current Assets
Current Ratio = Current Liabilities

• Quick Ratio firm’s ability to meet sudden and immediate demands on current assets.

Current Assets - inventory

Quick Ratio = Current Liabilities

Activity Ratios
Activity ratios are related to operations and operating efficiency because they measure how quickly the
firm is converting assets into cash. The more quickly the firm is able to move through the cycle from
inventory to accounts receivable to cash, the more profit they are likely to receive per peso of assets.

• Inventory turnover number of times the merchandise inventory was sold and replenish during the period.

Sales
Inventory Turnover = Average Inventory

• Days of sales in inventory – number of days inventory is sold, from the date acquired.

Number of days in a period

Days of sales in inventory = Inventory turn over

• Accounts receivable turnover number of times receivables have been realized in sales.

Net Sales
Accounts receivable turnover = Average Receivable

• Average collection period is also called “days of sales outstanding” the average collection period
describes the average time it takes to collect accounts.
No. of days in a year
Average collection period = Receivable turnover
• Fixed asset turnover = Net Sales / Average Fixed Assets (how effectively fixed assets have been utilized to
generate sales)

• Total asset turnover = Net Sales / Average Total assets (revenue ability of the firm in generating revenues;
a measure of investment efficiency).

Leverage Ratios
Debt or loan has a fixed value, if the company is making regular payments. If the firm is growing, it value
increases which goes back to stockholders in the form of dividends or reinvested capital.

a) Equity to debt Ratio = Owners’ equity / Total liabilities

- Shows the relationship between investor’s contribution and debt of the firm.

b. Debt ration = Total liabilities / Total Assets

- Proportion of assets provided by creditors

Profitability Ratios
Since the goal of most companies is to earn profit, these ratios are the most important to financial managers.

a) Gross profit margin = Gross profit / Sales

- Gross profit percentage on sales to recover operating expenses

b. Operating profit margin = Earnings (before interest and taxes)/ Sales

- Operating profit percentage per peso of sales

c. Net profit margin = Net profit (earnings after interest and taxes)/ average total assets
- Profit percentage per peso of sales

d. Return on Assets = Net profit (earnings after interest and taxes) / average total assets
- Overall assets productivity

e. Return on equity = Net profit / Average owners’ equity

- Rate of net income earned based on owners’ equity