CE 135 – ENGINEERING MANAGEMENT

Course Description:

This course deals with the study of the field of Engineering Management, the science of handling
technical undertakings the engineering way so that decision making shall be made more rational and
logical. It is concerned with planning and organizing technical activities, staffing the engineering
organization, communicating, motivating, leading, controlling, managing production and service operations,
managing the marketing functions and managing finance functions.

WEEK 17 – 18 . MANAGING THE FINANCE FUNCTION

Topics for Week 17 - 18:

1. What is Finance Function?

2. The Determination of Fund Requirements
3. The Sources of Funds
4. The Best Source of Financing
5. The Firm’s Financial Health
6. Indicators of Financial Health
7. Risk Management and Insurance

Learning Objectives:
At the end of the lesson, the students should be able to:

Topic 1. What is Finance Function?

The finance function is an important management responsibility that deals with the “procurement and
administration of funds with the view of achieving the objectives of business.” If the engineer manager is
running the firm as a whole, he must be concerned with the determination of the amount of funds required,
when they are needed, how to procure them and how to effectively and efficiently use them.

In the performance of his duties, the engineer manager, at whatever management level he is, must do
his share in the achievement of the financial objectives of the company.

The finance function is one of the three basic management functions. The other two are production and
marketing.

Topic 2. The Determination of Fund Requirements

Any organization, including the engineering firm, will need funds for the following specific requirements:

1. To finance daily operations

2. To finance the firm’s credit services
3. To finance the purchase of inventory
4. To finance the purchase of major assets

Financing Daily Operations

The day-to-day operations of the engineering firm will require funds to take care of expenses as they
come. Money must be made available for the payment of the following:

1. Wages and salaries

2. Rent

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 3. Taxes
4. Power and light
5. Marketing expenses like those for advertising, entertainment, travel expenses, telephone and
telegraph stationery and printing, postage, etc.
6. Administrative expenses like those for auditing, legal services, etc.

Any delay in the settlement of the foregoing expenses may disrupt the effective flow of work in the
company. It may also erode the public’s confidence in the ability of the company to operate on a long-term
basis. Creditors, for instance, may withhold the extension of credit to the company.

Financing the Firm’s Credit Services

It is oftentimes unavailable for firms to extend credit to customers. If the engineering firm manufactures
products, sales terms vary from cash to 90-day credit extensions to customers. Construction firms will have
to finance the construction of government projects that will be paid many months later.

Financing the Purchase of Inventory

The maintenance of adequate inventory is crucial to many firms. Raw materials, supplies and parts are
needed to be kept in storage so they will be available when needed. Many firms cannot cope with delays in
the availability of the required material inputs in the production process, so these must be kept ready
whenever required.

The purchase of adequate inventory, however, will require sufficient funding and this must be secured.

Sometimes, inventories unnecessarily tie-up large amount of funds. The engineer manager must devise
some means to make sure this situation does not happen

Financing the Purchase of Major Asset

Companies, at times, need to purchase major assets. When top management decides on expansion,
there will be a need to make investments in capital assets like land, plant and equipment.

It is obvious that the financing of the purchase of major assets must come from long-term sources.

Topic 3. The Sources of Funds

To finance its various activities, the engineering firm will have to make use of its cash inflows coming
from various sources, namely:

1. Cash Sales. Cash is derived when the firm sells its products or services.
2. Collection of Accounts Receivables. Some engineering firms extend credit to customers. When
these are settled, cash is made available.
3. Loans and Credits. When other sources of financing are not enough, the firm will have to resort to
borrowing.
4. Sales of assets. Cash is sometimes obtained from the sale of the company’s assets.
5. Ownership contribution. When cash is not enough, the firm may tap its owners to provide more
money.
6. Advances from customers. Sometimes, customers are required to pay cash advances on orders
made. This helps the firm in financing its production activities.

Short-Term Sources of Funds

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 Loans and credits may be classified as short-term, medium-term or long-term. Short-term sources of
funds are those with repayment schedules of less than one year. Collaterals are sometimes required by
short-term creditors.

Advantages of Short-Term Credits

When the engineering firm avails of short-term credits, the following advantages may be
derived:

1. They are easier to obtain. Creditors maintain the view that the risk involved in short-term
lending is also short-term. Thus, short-term credits are made easily available to qualified
borrowers.
2. Short-term financing is often less costly. Since short-term financing is favored by creditors,
they make it available at less cost.
3. Short-term financing offers flexibility to the borrower. After the borrower has settled his
short-term debt, he may consider other means of financing, in contrast, eliminates this
option. He is stuck with the long-term funds even if he no longer requires it.

Disadvantages of Short-Term Credits

Short-term financing has also some disadvantages. They are as a follows:

1. Short-term credits mature more frequently. This may place the engineering firm in a tight
position more often than necessary. When the frequency of the firm’s cash inflows is more
than twelve months apart, the firm could be in serious trouble meeting its short-term
obligations.
2. Short-term debts may, at times, be more costly than long-term debts. When short-term
debts are used to finance long-term expenditures, the frequent renewals, adjustment of
terms and shopping for new sources may prove to be more costly.

Supplies of Short-Term Funds

Short-term financing is provided by the following:

1. Trade creditors
2. Commercial banks
3. Commercial paper houses
4. Finance companies
5. Factors
6. Insurance companies

Trade creditors refer to suppliers extending credit to a buyer for use in manufacturing, processing or
reselling goods for profit. The instruments used in trade credit consist of the following:

 Open-book credit is unsecured and permits the customer to pay for goods delivered to him in a
specified number of days. For financially weak engineering firms, the open-book credit is a very
useful source of financing.
 Trade acceptance is a time draft drawn by a seller upon a purchase payable to the seller as payee
and accepted by the purchaser as evidence that the goods shipped are satisfactory and that the
price is due and payable.
 Promissory note is an unconditional promise in writing made by one person to another, signed by
the maker, engaging to pay, on demand or at a fixed or determinable future time, a certain sum of
money to, or to the order of, a specified person or to bearer.

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 Commercial banks are institutions which individuals or firms may tap as source of short-term loans: (1)
those which require collateral, and (2) those which do not require collateral.

Commercial paper houses are those that help business firms in borrowing funds from the money
market. Under this scheme, the business firm in need of funds issues a commercial paper, which is a short-
term promissory note, generally unsecured and issued by large, established firms. The commercial paper is
sold to investors through the commercial paper house.

Factors are institutions that buy the accounts receivables of firms, assuming complete accounting and
collection responsibilities. Engineering firms which maintain sizable amounts of accounts receivable may
avail of the services of factors when they are in dire need of cash.

Insurance companies are also possible sources of short-term funds. Industry reports indicate that
insurance companies in the Philippines regularly make investments in short-term commercial papers and
promissory notes.

Long-Term Sources of Funds

There are instances when the engineering firm will have to tap to the long-term sources of funds. An
example is when expenditure for capital assets becomes necessary. After amount required is determined, a
decision has to be made on the type of source to be used.

Long-term sources of funds are classified as follows:

1. Long-term debts
2. Common stocks
3. Retained earnings

Long-term debts are sub-classified into term loans and bonds.

Term Loans

A term loan is a “commercial or industrial loan form a commercial bank, commonly used for plant and
equipment, working capital, or debt repayment.” Term loans have maturities of 2 to 30 years.”

The advantages of term loans as a long-term source of funds are as follows:

1. Funds can be generated more quickly than other long-term sources.

2. They are flexible, i.e., they can be easily tailored to the needs of the borrower.
3. The cost of issuance is low compared to other long-term sources.

Bonds

A bond is a certificate of indebtedness issued by a corporation to a leader. It is a marketable security

that the firm sells to raise funds. Since the ownership of bonds can be transferred to another person,
investors are attracted to buy them.

Types of Bond

1. Debentures – no collateral requirement

2. Mortgage bond – secured by real estate
3. Collateral trust – secured by stocks and bonds owned by the issuing corporation
4. Guaranteed bond – payment of interest or principal is guaranteed by one or more individual or
corporations
5. Subordinated debentures – with an inferior claim over other debts

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 6. Convertible bonds – convertible into shares of common stock
7. Bonds with warrants – warrants are options which permit the holder to buy stock of the issuing
company at a stated price
8. Income bonds – pays interest only when earned

Common Stocks

The third source of long-term funds consists of the issuance of common stocks. Since common stocks
represent ownership of corporations, many investors are placing their money in them.

When properly utilized, common stocks can be cheaper and more stable sources of long-term funds.
Unlike bonds and term loans which must be repaid at a certain date, common stocks do not have maturity
and repayment dates.

Retained Earnings

Retained earnings refer to “corporate earnings not paid out as dividends.” This simply means that
whatever earnings that are due to the stockholders of a corporation are reinvested. Because these retained
earnings can be used by the firm indefinitely, they become an important source of long-term financing.

Topic 4. The Best Source of Financing

As there are various fund sources, the engineer manager, or whoever is in charge, must determine
which source is the best available for the firm.

To determine the best source, Schall and Haley recommend that the following factors must be
considered.

1. Flexibility
2. Risk
3. Income
4. Control
5. Timing
6. Other factors like collateral values, flotation costs, speed and exposure.

1. Flexibility

Some fund sources impose certain restrictions on the activities of the borrowers. An example of a
restriction is the prohibition on the issuance of additional debt instruments by the borrower.

As some fund sources are less restrictive, the flexibility factor must be considered. In general,
however, short-term fund sources offer more flexibility than long-term sources. This is so because
after settling the debt, short-term borrowers may shift to other types of financing. Long-term borrowers
are given this opportunity only after a longer period of waiting.

2. Risk

Risk refers to the chance that the company will be affected adversely when a particular source of
financing is chosen.

Generally, short-term debt “subjects the borrowing firm to more risk than those financing with long-term
debt.” This happens because two reasons:

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 i. Short-term debts may not be renewed with the same terms as the previous one, if they can be
renewed at all.
ii. Since repayments are done more often, the risk of defaulting is greater.

3. Income

The various sources of funds, when availed of, will have their own individual effects in the net income of
the engineering firm. When the firm borrows, it must generate enough income to cover the cost of borrowing
and still be left with sufficient returns for the owners.

It is possible that the owners were enjoying higher rates of return on their investments before borrowing
was made. The reverse may happen, however, at other times. Nevertheless, the effects on income must be
considered in determining the source of funding to be used.

4. Control

When new owners are taken in because of the need for additional capital, the current group of owners
may lose control of the firm. If the current owners do not want this to happen, they must consider other
means of financing.

5. Timing

The financial market has its ups and downs. This means that there are times when certain means of
financing provide better benefit than at other times, the engineer manager must, therefore, choose the best
time for borrowing or selling equity.

Other Factors

There are other factors considered in determining the best sources of funds. They are as follows:

1. Collateral values: Are there assets available as collateral?

2. Flotation cost: How much will it cost to issue bond or stocks?
3. Speed: How fast can the funds required be raised?
4. Exposure: To what extent will the firm be exposed to other parties?

Topic 5. The Firm’s Financial Health

In general, the objectives of engineering firms are as follows:

1. To make profits for the owners;

2. To satisfy creditors with the repayment of loans plus interest;
3. To maintain the viability of the firm so that customers will be assured of a continuous supply of
products or services, employees will be assured of employment, suppliers will be assured of a
market, etc.

Topic 6. Indicators of Financial Health

The financial health of an engineering firm may determine with the use of three basic financial
statements. These are as follows:

1. Balance sheet – also called statement of financial position;

2. Income statement – also called statement of operations

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 3. Statement of changes in financial position

Topic 7. Risk Management and Insurance

The engineer manager, especially those at the top level, is entrusted with the function of making profits
for the company. This will happen if losses brought by improper management of risks are avoided.

Risk is a very important concept that the engineer manager must be familiar with. Risks confront people
every day. Companies are exposed to them.

Definition of Risk

Risk refers to the uncertainty concerning loss or injury. The engineering firm is faced with a long list of
exposure to risks, some of which are as follows:

1. Fire
2. Theft
3. Floods
4. Accidents
5. Nonpayment of bills by customers (bad debts)
6. Disability and death
7. Damage claim from other parties

Types of Risk

Risks may be classified as either pure or speculative. Pure risk is one in which “there is only a chance of
loss.” This means that there is no way of making gains with pure risks. Pure risks are insurable and may be
covered by insurance.

Speculative risk is one in which there is a chance of either loss or gain. This type of risk is not insurable.
Operating the engineering firm is a kind of speculative risk. If profits are expected, then proper management
techniques must be used.

What is Risk Management?

Risk management is “an organized strategy for protecting and conserving assets and people.” The
purpose of risk management is “to close intelligently from among all the available methods of dealing with
risk in order to secure the economic survival of the firm.”

Risk management is designed to deal with pure risks while the application of sound management
practices are directed towards speculative risks that are inherent and cannot be avoided.

Methods of Dealing with Risk

There are various methods of dealing with risks. They are as follows:

1. The risk may be avoided

2. The risk may be retained
3. The hazard may be reduced

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 4. The losses may be reduced
5. The risk may be shifted

A person who wants to avoid the risk of losing a property like a house can do so by simply avoiding the
ownership of one.

Risk retention is a method of handling risk wherein the management assumes the risk. A planned risk
retention, also called self-insurance, is a conscious and deliberate assumption of a recognized risk. In this
case, management decides to pay losses out of currently available funds. Unplanned risk retention exists
when management does not recognize that a risk exists and unwisely believes that no loss could occur.

Hazard may be reduced by simply instituting appropriate measures in a variety of business activities.

When losses occur in spite of preventive measures, the severity of loss may be limited by way of
reducing the concentration of exposures. Examples of efforts on loss reduction are as follows:

1. Physically separating buildings to minimize losses in case of fire;

2. Using fireproof materials on interior building construction;
3. Storing inventory in several locations to minimize losses in cases of fire and theft;
4. Maintaining duplicate records to reduce accounts receivable losses;
5. Transporting goods in separate vehicles instead of concentrating high values in single shipments;
6. Prohibiting key employees from traveling together;
7. Limiting legal liability by forming several separate corporations.

Another method of handling risk is by shifting it to another party. Examples of risk shifting are hedging,
subcontracting, incorporation and insurance.

Hedging refers to making commitments on both sides of a transaction so the risks offset each other.

When a contractor is confronted with a contract bigger than his company’s capabilities, he may invite
contractors in so that some of the risks may be shifted to them.

In a corporation, a stockholder is able to make profits out of his investments but without individual
responsibility for whatever errors in decisions are made by the management. The liability of the stockholder
is limited to his capital contribution.

To shift risk to another party, a company buys insurance. When a loss occurs, the company is
reimbursed by the insurer for the loss incurred subje0ct to the term of the insurance policy.

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