ARELLANO UNIVERSITY

Andres Bonifacio Campus

Pag asa st., Caniogan Pasig City

HANDOUTS NO.2
LESSON 01:
THE FINANCIAL SYSTEM

In knowing Business Finance, it is very much needed to understand how Financial wealth
flows. With this, understanding the Financial System seems to be very important. The financial
system links the savers and the users of funds.

The SAVINGS mentioned on the financial system can come from households, individuals,
companies, government agencies, or any other entity whose cash inflows are greater than their
cash outflows. Savings are also known as the SOURCE of the Financial system.

In the middle of the financial system, we have the FINANCIAL INTERMEDIARIES.

These Financial intermediaries provides a mechanism by which these savings can be directed to
users of funds, borrowers, and investors. Some of the financial instruments issued by users of funds
such as the shares of stocks and corporate bonds of publicly listed companies and the debt
securities issued by the National Government has traded.

The end part of the Financial system are the USERS. These users includes Households,
Individuals, Corporations/Companies and Government Agencies that needs fund to finance their
needs/operations.

1. FINANCIAL INSTITUTIONS are companies in the financial sector that provide a broad
range of business and services including banking, insurance, and investment management.
Examples of financial institutions/Intermediaries:

A. 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.

B. 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 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.

a. MUTUAL FUNDS –
Mutual funds owned by investment companies that 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.

b. 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.

2. FINANCIAL INSTRUMENTS
-is a real or a virtual document representing a legal agreement involving some sort
of monetary value. These can be debt securities like corporate bonds or equity like shares of stock. When
a financial instrument issued, it gives rise to a financial asset on one hand and a financial liability or
equity instrument on the other.

a. 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

b. 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
 c. 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

d. Debt Instruments
generally have fixed returns due to fixed interest rates. Examples of debt
instruments are as follows:
• Treasury Bonds and Treasury Bills 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 has been paid.

• Corporate Bonds 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 issued the bonds goes
bankrupt, the holder of the bonds will no longer receive any return from their investment and even their
principal investment has wiped out.

c. 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 has liquidated and its assets have to be distributed, no
asset be distributed to common stockholders unless all the claims of the preferred stockholders
has 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 given to common stockholders unless all the dividends due to preferred stockholders
paid first. (Cayanan, 2015)

• Holders of Common Stock

on the other hand are the real owners of the company. If the company’s growth is
encouraging, 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.

3. FINANCIAL MARKET –
refers to a marketplace, where creation and trading of financial assets, such as
shares, debentures, bonds, derivatives, currencies, etc. take place.

Classify Financial Markets into comparative groups:

1. 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 public referred to as a public offering and the first offering of stock
named 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
purchased. The sale of previously owned securities takes place in secondary markets.
• The Philippine Stock Exchange (PSE) is both a primary and secondary market

2. MONEY MARKETS VS. CAPITAL MARKETS

•Money markets are a venue wherein securities with short-term maturities (1 year or less) are sold. They
have 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.

The role of Financial Managers: make financing decisions that require funding from investors in the
financial markets.

References:
Business Finance by Cayanan A. (2017)
Business Finance for Senior High School by Flores M. (2018)