FM 101 REVIEWER
CHAPTER 1:
 Role of Financial Management
1. In the past, to secure funds needed by the business
enterprise.
2. Present important developments have changed. The
recognition that business and industry must operate within
highly competitive atmosphere necessitated management to
use it resources economically and efficiently. One source is
financial.
 Financial Management - is changed with important and
significant tasks and responsibilities.
 Financial Executives an Overview
Members of the Financial Executives Institute have major financial
responsibilities in their companies.
1. Chairman of the Finance Committee of the board of directors.
2. Vice President of Finance
3. Controller
4. Chief Financial Officer
 Expanding Role of Financial Management
The financial executive's role in large corporations has
expanded significantly, with functions such as Vice President of
Finance, Chief Financial Officer, and Treasurer all viewed as
financial executives.
 Controller - as a financial executive is applied to various
accounting positions, the duties of which vary from one
company to another
 Smaller Firms, the controller is nothing more than a glorified
senior bookkeeper
 Bigger Firms, he or she is a key executive. In most firms, the
controller is between these two extremes. In this book, the
controller is the chief management accounting executive and as
one of the financial executives decides and recommends
objectives, set goals and involves himself heavily with these
goals.
 The function of top and financial management - is to manage a
business which can achieve its objectives within the existing
framework of the economy and the objective of the nation's
economy.
 The following statements express this:
• "The decisions made by businesses, when added together, are
crucial for making the economy stable or unstable. The
individual businessman should do everything he can make the
economy more stable, consistent with his responsibility for
economic efficiency and expansion".
• First of all, the businessman can improve the things he does.
He can develop new products to satisfy new demands, wants
and needs. He may improve his production methods to cut costs
and bring more products. He can improve his selling techniques.
• He can keep his inventory down to the minimum level needed
for efficient operation in avoid speculation.
 Scope of financial management
The following finance function in business make up the broad
areas of financial management;
1. Financial planning - includes the preparation and translation
of the short and long term of the funds needed to consummate
such plans and programs. It includes:
A. Cash budgeting - a major responsibility of financial
management is to maintain an adequate cash position to enable
the business to meet possible contingencies. - its main objective
is to determine the remaining cash resources that will be
available during the period.
• A profitable business, as indicated by its profit or loss
statement, maybe starved for cash and may in fact be in danger
of technical insolvency or temporary insolvency. • Technical
insolvency - exist when a business enterprise is unable to meet
cash payments due on contractual obligation.
• Legal insolvency - exist when assets amount to less than its
recorded liabilities as brought by successive losses.
B.Raising Money - can be done directly from owners, through
partnerships, or through corporations. However, debts can limit
this method. Credit facilities and selling ownership shares can
also be used.
C. Borrowing Funds - this can be in long term or short term.
D. Raising Funds Through the Sale of Notes and Bonds - when
funds are needed for long term purposes, as in the acquisition of
fixed assets involving considerable amounts of money, notes
and bonds may be sold.
• Bonds of long time finance are described as "second
promissory notes of the issuing corporation regardless of the
time of maturity".
• Notes include "all unsecured promises to pay."
• Another distinction between the two is that a debt due less
than one year from date of issue is usually called a note.
E. Leasing property - is another alternative to buying it and
raising funds to finance the purchase. It is a crucial method for
corporations to expand operations without acquiring assets.
• Short-term lease is used by a small businesses for rent offices,
stores, and factories.
• Long-term lease cover buildings, factories, and real estate.
2. Cash Management - Profit is the primary goal of any business, and
effective cash management involves managing working capital,
including cash and marketable securities, to ensure financial stability.
Includes:
A. Handling Cash Receipts - cash receipts from operations consists of
cash sales and collection of receivables representing sales on credit
terms. The distribution of cash receipts from sales throughout the
budget depends upon the following;
aa) the regularity of sales.
bb) the proportions of cash and credit sales
cc) the terms of sales
dd) the amount collected from receivables.
B. Cash Disbursements for Operations - are developed from the sales
estimates.
C. Custody of Petty Cash Funds - even though the business policy is to
make all payments by checks, there are occasions when it necessary
to pay cash.
• Petty cash funds - the special funds that are set up in a company to
make up for such kinds of payment.
• the financial executive or manager is responsible for setting up in
supervising the administration of petty cash funds, which entail the
use of some system for purposes of controlling disbursements of petty
cash.
D. Responsibility for Bank Deposits - Bank deposits should be safe
and secure, with the Philippine Deposit Insurance Corporation
ensuring depositors up to 23,000 pesos. Other factors include prompt
service, accessibility, and loan grants.
E. Investing Funds not needed immediately - into investments
yielding high returns with safety is a wise policy, focusing on expected
rate of return and blue chip stocks.
F. Custody of Marketable Securities - Financial managers are
responsible for custody of various securities, including stocks, funded
debts, bonds, and notes, which can be traded in the stock exchange
market.
3. Management of Receivables - a joint responsibility with the
marketing department is developing and carrying out credit policies,
which include the following:
A. Determining who shall be granted credit - Credit can be abused,
causing chaos and limiting business growth. It's crucial to determine
who should be granted credit, as limiting it to a few can eliminate risk
but also limit sales volume. Creditors must protect their investments
and ensure timely payment.
B. Determining the Amount - Companies impose credit limits,
determining the maximum outstanding credit amount through a
credit analysis. These limits are not to be extended, but rather to
comply with requirements for credit purchases.
• temporal credit limits is defined as the type of credit limit which
does not lessen the amount of credit to which a prospective border or
debtor may avail himself provided certain stipulated requirements are
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accordingly met and complied with.
C. Bill Collection - Effective bill collection is crucial for granting credit
and maintaining creditworthiness, as failure to enforce obligations can
lead to poor credit risks.
4. Determining Policies on Investments in Inventories and Fixed
Assets - large inventories do not help the company. In fact, it could
precipitate the onset of recession. Therefore, sound policies on
investment in inventories are both compelling and important.
A. Establishing policies on investment in inventory - Progressive
companies should focus on long-term investments in inventory,
ensuring they generate income through productive use and not
neglect current operations.
• One way of controlling investment in inventories is through the cash
budget, which will show any deviation from budgeted amounts.
• Another is through the use of ratios. The ratio of sale to inventory
should be figured regularly to determine any inventories getting out of
line
B. Relationship of inventories and fixed assets - the relationship
between inventories and fixed assets differs from receivables in
finance. Inventories take longer to convert into cash, while fixed
assets are converted more slowly due to their long writing period. The
total amount invested in fixed assets is crucial for financing, while the
sustainability of assets is equally important. The types of goods in
inventory and their amounts are part of the sales function.
5. Controlling the finances of a business - the financial officer, a top
management member, plays a crucial role in planning and
implementing policies to control a business's finances. They are
responsible for financing and controlling internal expenses by
comparing actual and budgeted expenditures. Regular checks are
conducted to ensure the interest or dividend rate is not out of line,
and any higher rates should be investigated and stopped if possible.
6. Participation in determining policies on dividends - to develop a
dividend policy, companies should observe and learn from reputable
firms. Most mature firms have two types of dividend policies: regular
dividends for reward and public relations, and a constant percentage
of earnings. Regular dividends are used to elevate a company's stock
to blue chip status, while a constant percentage avoids excessive
market repercussions of changing dividends.
• Companies can pay cash or stock dividends to their stockholders,
depending on factors like growth, maturity, and retained earnings.
New businesses may back all or a large part of earnings, while mature
companies may pay out a large proportion. Stock dividends are
generally not taxed.
 Training and Development of Financial Executives
• Financial executives' training and development programs have
three main objectives: reducing executive dropouts, retaining
qualified employees for higher roles, and ensuring all employees
are well-qualified to carry out their tasks.
• W. Joseph Littlefield, a retired controller for Johns-Manville
corporation, emphasized the importance of a company's culture
and knowledge to avoid executive dropouts.
 Qualities Desired of Financial Executives - successful financial
executives exhibit certain desirable qualities which they have
developed to their great advantage through a program of
training and development. Among such qualities found to be
most useful are;
A. Aptitude for mathematics - Financial executives must excel in
mathematics to quickly read reports and detect errors in data or
calculations, as they cannot escape using numbers in their job.
B. Ability to think straight - A good financial executive must
possess good judgement and logical reasoning skills to identify
financial problems and provide sound conclusions.
C. Ability to express thoughts with clarity - The executive's
inability to clearly express thoughts and ideas can be frustrating
for staff, as it limits their understanding of the job.
D. Ability to visualize - Successful people possess the ability to
visualize and predict events, often utilizing intuition, a
conventional way of thinking that helps them understand their
actions.
E. Ability and willingness to absorb new ideas - The financial
executive's willingness to accept new ideas from top
management fosters commitment from employees, ensuring a
diverse and inclusive company culture.
F. Ability to deal with people - Financial executives require
cooperation from others for audit tasks in financial
management. Success relies on public relations and the golden
rule, emphasizing the importance of public relations.
CHAPTER 2: CORPORATE FORM OF BUSINESS ORGANICATION
 The modern corporation is established primarily to attract large
capital and assure its permanence in today’s industry.
 Importance: Among large business units in most major fields of
industry, the corporate form is predominant. Although a little
over 15% of business organizations are corporations, they
account for no less than 75% of business transactions done
annually. The rapid industrial development, which took place in
the United States, is a contribution of the corporate form of
organization without which it would be impossible to finance
many modem undertakings.
 Early Origin: The concept of corporate organization has been
around for centuries with origins in Roman history. Initially
applied to municipalities, religious institutions, and educational
establishments centuries ago. In Great Britain specifically early
corporate bodies were granted charters by royal decree. The
power to grant charters has always been part of the prerogative
of the Crown. Historically, the Crown has used this power to
support ventures of national importance, such as overseas
trading companies like the Merchant Adventurers (1390) and
the East India Company (1600). The majority of corporations
formed in Great Britain prior to the 18th century served local
government, charitable, or educational purposes, with some
being established for foreign trade expansion or colonization.
 Corporation is means by which the small and scattered money
hoards of millions of individuals are gathered together into large
aggregates capable of producing and distributing goods in
quantity.
 Essential Attributes: When a company is legally incorporated, as
evidenced by the grant of a charter by the state, it is granted
specific powers to engage in lawful activities as outlined in the
charter.
 ByLaws - is a rule adopted by an organization chiefly for the
government of its members and the regulation of its affairs.
 Annual Meetings - superficial affairs, presided over by the
directors and managers, whose ownership is usually minor.
 3 Groups in a Corporation
1. Stock Holders - they are the owners of the business, having
invested their funds in the organization.
• Debt capital - funds advanced by by the creditors.
2. Directors - they are elected by stockholders. Directors are
personally liable if they;
a. Wrongfully dispose of corporate assets
b. Pay dividends in the absence of profits or surplus
c. Issue fully paid stock, which actually has not has not been fully
paid, and
d. Lend corporate funds to stockholders.
3. Officers The Boarder of Directors - had the primary
responsibility of managing the affairs of the corporation.
• Ultra vires act - acts committed outside the scope of a
corporation's charter.
 Importance of Organization
Organization is a basic management process, which provides a
tool of importance to the successful execution of managerial
tasks. It is where action is taken and determines in large
measure the effectiveness with which major decisions are
implanted and policies and practices are followed.
 Advantages and Disadvantages of Corporation
Advantages of Corporation
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• It is evident that the corporate form of organization provides
greater ease in acquiring large amounts of capital.
• It can attract all kinds of investors, which is an advantage over
the other forms of business organizations.
• Case in the transfer of shares of ownership
• Corporations enjoy continuous existence
• Their liability extends only up to their unpaid subscriptions to
the corporation.
Disadvantages of Corporation
• The corporation is not immune from certain shortcomings,
even with its numerous advantages. Its activity is limited by the
powers granted to it in its charter.
• The corporation is subject to certain requirements. The
submission of annual reports and high taxation's are very
burdensome for the business.
 Financial Administration of Corporation
• Small Corporation
All phases of the finance function are handled by the Treasurer.
There has been no uniform practice in dividing the functions
handled by the Treasurer and the Controller, who both exist.
• Large Corporation
Financial management is lodged on the finance committee of
the Board of Directors. When a Vice President for finance or a
finance committee of the Board exists, they are responsible for
the basic policy determination with respect to financial matters
affecting the business.
a) Recommending depository banks for company funds b)
Maintaining good relations with lending institutions
c) Analyzing the need for capital expenditures
d) Formulating credit policies
e) Investing surplus funds
f ) Planning financial requirements
g) Preparing the annual report to stockholders and handling long
and short-term financing;
• Middle Sized Corporation
Treasurer and Controller are responsible directly to the
President.
• Treasurer’s Duties
a) Supervision on payments of dividends and interest
b) Purchase and sale of securities
c) Establishment of surety bond requirements
d) Handling the insurance program covering all assets and risks
e) Reviewing contracts for financial and tax matters
f ) Care of petty cash funds
• Controllers
The Controller is in charge of general, and cost accounting
system, internal auditing and development and operation of the
budget.
 Responsibilities of Financial Management
• Financial management means maintaining the business in
sound financial health and endeavors to generate earnings that
will adequately reward the owners for the use of risk capital
they provide.
• Financial management owes an administration that will keep
the business solvent and liquid, with asset values adequate to
support the debt and earnings sufficient to retire it.
• Financial management is also responsible to the business
enterprise against the background of its many legal obligations
such as taxes and those affecting its operations with the
objective of assuring public welfare.
• Good financial management also helps to develop a sound
legal framework in which opportunity and ingenuity have a
chance to live.
• All have an important stake in the successful operation of the
business enterprise.
CHAPTER 3: EQUITY CAPITAL COMMON AND PREFERRED STOCK
 The Nature of Ownership in a Corporation
• Corporate business organizations are separate entities from
their stockholders, but accounting for ownership and
transferring ownership can be complex.
• Two types of capital accounts are used: capital stock and
retained earnings.
• In a corporation, creditors have limited liability against
stockholders' personal assets.I
• In a partnership, net income is transferred to the partner's
capital accounts.
• Legal capital represents the specific contribution by
stockholders for creditors' protection.
• Capital Stock Account - the amount of common and preferred
shares that a company is authorized to issue.
• Capital Surplus Account - the additional paid-in capital in
excess of par value that an investor pays when buying shares
from an issuing entity.
• Paid-in Surplus Account - the incremental amount paid by an
investor for a company’s shares that exceeds the par value of
the shares.
 Capitalization of a Business Organization
• Capitalization
- held to mean the total value of all the securities, stocks and
bonds issued by a corporation at a given time.
- refer to the total par value of the authorized capital stock of a
corporation.
• Par value - the capital stock of a corporation may be assigned
a fixed value in the articles of incorporation. This value which is
also printed on the stock certificate.
• No par stock - stock may also be issued without par.
- do not have face value indicated on the certificate
• There are shortcomings noted in the issue ones of par value
stocks:
1. It leads the an informed owner of par value stock to think of
the par value as the real value of his shares in the market.
2. The requirement that the corporation must receive the full
par value before the stock is "fully paid and non-assessable" at
times makes it difficult to sell the shares in the market
particularly so when the market value has declined below the
par value of the unissued shares.
3. When par value stock is issued to some of the organizers for
property or services and additional cash is to be raised by
sharing shares below par value, it becomes a device designed to
limit the stockholders liability on shares sold below par value to
the amount the organizer agrees to pay for the stock.
 Basis of Capitalization
Opening a new business requires careful planning for future and
current needs, avoiding the risk of raising excessive or
insufficient capital. Insufficient funds can hinder investment,
lead to hasty decisions, and limit development opportunities,
posing risks to sound borrowing.
• The par value of the capital stock actually issued should be
equal to the "cost" off the newly-launched business.
• Cost theory - where the amount of capitalization is based
upon the original, out-of-pocket investments in plant,
equipment, etc.
• Earnings theory - earnings, as a test or measurement of the
amount of capitalization, may have some significance.
 Issuing Securities
Organizers or incorporators develop their financial plan, apply
for capital authorization, and decide on securities type to issue
at corporation organization or after test period.
• Capital structure
- the make-up of the capitalization of the corporation.
- can be called sound if it is suitable both for current and
changing conditions that may likely develop in the future.
 Common stock
• The capital stock of a corporation is usually divided into two
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classes:
1. Common Stock
- shares of ownership in a corporation and the type of stock in
which most people invest.
- voting rights
• Classes of Common Stock - Common stock may be classified
as:
1. Par stock - has a stated legal peso/dollar amount.
2. No par stock - does not have a given value.
• Characteristics: The important characteristics of common stocks
are:
1. Common stockholders take greater risk and as such obtain greater
share of profits.
2. Dividend payments are not guaranteed.
3. Owners do not suffer from a fixed limit as to the earnings from the
investment.
• The Cost of Common Stock
Computation of the cost of capital from the sale of common stock is
doubtless similar in nature to that of preferred stock. Like preferred
stock, common stock is issued in perpetuity. The income used is the
firms current dividends per share plus expected capital gains these
profits are likewise presumed to persist into respectful.
• Archer and D'Ambrosio offer the following formula for the cost of
capital for the sale of common stock as: Kc = EO/ P
EO refers to income, that is estimated current dividends per share
plus expected capital gains.
P represents the current market price per share.
Kc equals the cost of common capital.
• The ratio of EO to P is called a profits-to-price ratio or a profit yield.
P10/P100 × Percent²
2. Preferred stocks
- is stock which has some preference over common stock in claims to
dividend payments or in the distribution of assets and liquidation.
- usually takes precedence in the event of liquidation.
• Reasons for Issuing Preferred Stocks
A corporation may issue preferred stocks for various reasons,
including financial gain, management control, and temporary rights.
Common stockholders typically vote by proxy, making increasing
voting shares minor. Preferred stockholders retain certain permanent
voting rights and can obtain temporary rights for statutory
requirements or investment banker insistence.
• Characteristics of Preferred Stocks
Preferred stock has evolved over time, with preferences ranging from
receiving dividends before common stock to making dividends
cumulative. In cases where dividends are postponed, the board may
provide cash to offset arrears, but this would be meaningless unless
earnings are high enough to pay the dividends. To avoid this,
corporations may provide non-cumulative dividends on preferred
stock issues.
Preferred stock also has a preference for assets in liquidation, with
preferred stockholders paid the full par value before common stock.
Directors have no voting rights but can vote on major issues affecting
their position. Recent issues of preferred stock often include a call
provision, which allows the issue to be called at any dividend date.
• Call provision - the issue can usually be called at any dividend date
by giving the prescribed notice ahead of time.
• Call price - is almost always above par and generally decreases on a
regular basis for a period of years until it reaches par.
• Sinking fund - is much more common in the case of industrial
preferred stock than in the case of utility preferred stock.
• Preemptive Right - is practically never given to preferred stock.
• Preferred Stock with Special Features
A corporation may find it advantageous to issue preferred stock with
special features. Its rights to dividends depend on the following:
1. Participating preferred - use primarily to attract investors who may
be unwilling to buy straight preferred or common stock in a
corporation.
2. Convertible preferred - conversion features is another more
frequently added inducement to make a prepared stock more
attractive to investors, giving it special privilege features to change it
into common stock.
• A number of situations may bring about such conversion:
a. When dividends on uncommon stock are larger than a preferred
stock to offset the added risk
b. When the conversion privilege is about to expire and the value of
the preferred stock.
c. When the convertible preferred stock is to redeemed and the value
of the common stock is greater than the redemption price of the
preferred stock
d. When other advantages possessed by common stock justify such
conversion.
 Privileged subscription - is applicable to sales of securities to
former stockholders where there is financing with transferable
subscription through the exercise of preventive right.
 Commulative and Noncommulative
• Commulative - when a corporation lacks earnings to pay
dividends on its preferred stock the question arises whether the
past dividend must be paid in the future years. - it accumulates
and must be paid off.
• Noncommulative preferred stocks - are rarely sold, if ever, in
order to raise money.
 Redemption on Retirement of Preferred Stocks
The rights and privileges of preferred stockholders with the
resulting restrictions on management may make it desirable to
eliminate preferred stock outstanding. This may be done in
several ways, such as:
1. Calling the issue and the financing it in some less burdensome
way.
2. Using a retirement or sinking fund with provisions for
compulsory surrender of preferred stock.
3. Purchasing the stock directly from stockholders or in the open
market.
 Other types of Stock
1. Treasury stock - a stock which has been previously issued by
the corporation but is no longer outstanding.
2. Founders stock - issued to the founders of the corporation for
their services in organizing it and as such are at times called
managers shares.
• Founders shares - relatively small in amount and frequently
carry the provision that after preferred stocks are paid any
remaining balance available for dividend payments shall be
divided equally between the common stock and the founders
stock.
3. Promoter stock - is more or less similar to the founders stock
in that it is intended to serve as a reward for the services of
promoters.
4. Protected preferred stock - done by placing in reserve a
certain amount after the prepared dividend has been paid.
5. Deferred stock - kind of stock on which the payment of
dividends is postponed until payment has already been made on
another class of stock.
4. Guaranteed stock - a company binds itself to be responsible
for the payment of dividends on stocks issued buy another
company.
5. Debenture stock - commonly known as debenture bonds.
6. Prior preference stock - issued upon prior consent of the
majority of stockholders.
 Status of Stocks
Apart from the various classifications of stock discuss in the
foregoing paragraphs, authorized stock maybe issued or inissued
and according to their status they may be part-paid or full-paid.
• Full-paid stocks - are those which have been fully paid by the
owners to the corporation issuing them, weather in terms of
cash, property or services.
• Part-paid stocks - are those for which only a limited or partial
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payment has been made by their owners.
• Stocks which have been issued by a corporation and are in the
hands of the stockholders whether full-paid or part-paid, are
term as outstanding stocks.
• When such a stocks are acquired by the corporation through
purchase, they constitute what are known as treasury stocks.
 Over - Capitalization and Under - Capitalization
• Over - Capitalization - exist when the corporation issues
securities with the stated value in excess of the market value of
the net worth of the business enterprise, commonly known as
watered stock.
• Under - Capitalization - exist when insufficient provision is
made for funds to operate on the most productive basis.
CHAPTER 4: Decisions on Financing
 Under both public and private ownership, the function pf
finance do not differ insofar as the raising of capital,
administration of income, management and direction are
concerned.
 Private Ownership
•Finance offers a very crucial test with respect to efficiency.
•Failure becomes a heavy blow for the owners of the business.
 Public Ownership
•Failure may be mitigated through resort to taxes
 The important role of finance has two major functions:
1. it is a means of assembling the funds necessary to initiate a
new business.
2. it provides a basis for continued operations.
 Underlying these two functions are:
1. Planning
2. Management
 Finance
- described as the science of monetary affairs, is only one aspect
of every business management but a very important one.
 Basic Factors to Consider
Any decision process involves selection of a course of action
from two or more alternatives. Such factors among others
include the amount of money to be raised, purpose, source, cost
of capital, risk, time period, etc.
 Amount of Capital
• Varies from industry to industry
• The greater the production, the more capital the company will
need.
• More Capital for working operations.
 Sources of Funds
• There are two major sources of funds that corporations use to
acquire the assets they need:
1. Internal sources of funds - generated within the business.
2. External sources of funds - include short-term borrowing,
long-term borrowing with bond issues and mortgages, and
equity financing through the sale of preferred stock or common
stock.
 Selling Corporate Securities - is not similar to selling
commodities.
 Investment Banking House
It is to bring together the company needing investments and the
prospective investors who are looking for profitable investment
opportunities by which they could put their idle funds to work
and earn incomes for them.
 Purpose and Type of Financing
Current needs of the business may be financed through bank
loans, as in the case of an unsecured promissory note, a line of
credit and other commercial documents.
 Line of Credit
This will enable the corporation to know in advance how much it
can borrow at a particular time, without the need of a collateral,
should circumstances necessitate the same.
 Bankers of Acceptance
It is a method of obtaining funds that may be defined simply as a
draft drawn by the seller upon the bank (instead of upon the
buyer himself, as in the case of trade acceptances).
 Inventories as Loan Security
Under this method, a certain portion of the plant's premises is
cordoned off for the storage of the inventory assigned to secure
the loan.
 Accounts Receivable
- developed in specialized finance companies, just as many other
types of loans which banks have recently begun to make
- carried on by banks differs from factoring in that the accounts
are not taken over outright but are used as the basis for a loan.
 Bill of lading financing
When a firm immediately needs cash for a shipment of goods to
a customer, at draws a draft on the buyer and uses the bill of
lading as collateral, provided the goods are salable and not
perishable.
 Cost of Capital
Capital has a cost. What this cost will be depends upon the
various sources available and the ease or difficulty of obtaining
such capital. The supply of capital may be high or low in relation
to the quantity of funds sought.
 Average Cost of Capital
Weighted average cost of capital (WACC) represents a
company's average after-tax cost of capital from all sources,
including common stock, preferred stock, bonds, and other
forms of debt. As such, WACC is the average rate that a
company expects to pay to finance its business
 Risk Involved
All financing involves a certain degree of uncertainty or risks.
The risks which affect all business operations also affect the
financing of the business. Some risks may arise out of the
operation of the business itself. Others, however, are brought
about by outside economic forces.
 Time period of financing
Not only do the risks in any financing affect the choice between
alternatives but management's reaction to real or assumed risks
is also significant and probably often one of the most significant
factors. This will depend upon the psychological makeup of
individuals involved and their general reaction to uncertainty.
 Lease Financing
- Financing by enterprise ordinarily has the purpose of acquiring
additional assets.
- They may be rented instead and payments for their use are
then distributed over the period of time the services of the
assets are being provided.
 Rentals - can be based on hourly, daily or weekly rates, with
payments applicable to the time that possession of the utilities is
retained.
 Character of leasing
A financial lease is similar to debt in that it requires an obligation
to make a fixed payment to the lessor so that principal and
interest may be recovered. In general, financial losses cannot be
cancelled. Once the use of the particular piece of equipment has
been determined profitable and the choice of debt financing
over equity has been made, lease financing be- comes an
alternative to borrowing.
 Type of Leases
• Financial Lease - a type of commercial lease in which a finance
company is the legal owner of an asset, and the user rents the
asset for an agreed-upon period of time.
• Operational lease - a contract that allows for an asset's use but
does not convey ownership rights of the asset.
 Nature of Leases
• Leases are flexible economic arrangements based on
contractual relationships and can therefore include whatever
provisions are inserted. They sometimes place responsibility for
maintenance and expenses on the lessor, especially if servicing is
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important.
• A leasing decision is not a pure investment decision. It is partly
a financing decision.
• A lease, then, is equivalent to a combination buy-and-borrow
alternative.
 Sale and Lease Back Financing
The so-called "sale-and lease- back financing as a device
designed for the acquisition of additional working capital is
intended for use in business expansion of the post liberation era.
CHAPTER 5: Short-term Financing
 Financial management is crucial for businesses to meet demands
and effectively manage resources. Executives must determine
borrowing amounts, time, and credit liquidation programs.
Common borrowing needs involve clearly defined purposes,
amounts, and durations. A responsible, limited term,
determinable amount, and predictable means of liquidation are
essential for short-term financing, as they are a reliable solution
in the money market.
 Short-term credit - describe as any type of financing that is
negotiated for, unexpected to be paid within, a 1 year period.
 Sources of Capital
• The most important sources of capital available for short
periods are:
1. Loans obtained through the use of commercial papers
2. Clones from finance companies in banks.
 Trade credit - interbusiness credit is the most important form of
short term credit known as trade credit.
 Trade discount - a very common term which refers to a
percentage reduction from the least price allowed by
manufacturers to wholesalers and wholesalers to retailers.
 Principles Governing Extension of Trade Credits
Not all merchants are entitled to the use of trade credit. the
suppliers of merchandise analyze the credit standing of a
business, similar to that used by commercial banks
 The Mechanics of Trade Credit
• Delivery of the goods by the seller and acceptance by the
buyer establishes the trade debt, which becomes an account
receivable for the seller and account payable for the buyer
• In most sales, the debt is handled on an "open account" basis.
• The terms of trade credit usually refer to two periods:
1. A brief period - frequently 10 days during which the buyer
may take a discount on the face amount of the purchase billing.
2. Longer period - represents the number of days permitted
until maturity when the full amount of the bill is expected to be
paid.
• 10 EOM (full amount due 10 days after the end of the month
in which the transaction took place, the usual terms of personal
charge accounts at retail stores).
• COD (CASH ON DELIVERY)
 Accounts Receivable Financing
• A new or rapidly expanding business with a limited capital
base by generate a need for a larger amounts of money than an
unsecured bank loan can provide.
• Such companies have long relied on upon accounts receivable,
also called "commercial" financing.
 Advantages
At this point, a number of advantages, which weigh in favor of
this type of financing, maybe noted.
1. It would be used to obtain more operating cash than from any
other source on a continuing and flexible basis.
2. It helps the increase of capital turnover in a greater return on
invested capital.
3. It enables the company to make advantageous purchases
requiring cash and the consequent improvement of credit by
discounting suppliers bills.
4. It tends to eliminate the undesirable alternative of seeking
equity capital or taking in partners and diluting the owner's
control of the business.
5. Financing accounts receivable give s a significant leverage to
limited investment capital at a substantial and recoverable base.
 Mechanics of Financing Accounts Receivable
1. A contract or agreement is drawn between the business
concern and the financing institutions.
2. The loans are made with "recourse" to the firm but without
notice to its customers.
• "With recourse" means that if a client's customers becomes
delinquent or his account becomes uncollectible pro but every
reason.
• "without notice" means customers are not notified that their
receivables have been pledged, to accommodate certain trade
conditions.
3. The client passes on its own credits makes deliveries on
regular trade terms.
4. The lender usually agrees to advance some fraction of the
face value of the receivables pledged.
5. As the receivables are paid, the borrower forwards the
proceeds often the customers actual check to the lending
institution.
 Pledging of Inventories
Receipts for goods stored in bonded public warehouses of field
warehouses and certain other titles to physical inventories may
be used as collateral security for loans.
 Field warehouse - a natural development of the principle of
using warehouse receipts as collateral for bank loans.
 Trust receipt - maybe describe simply as "a receipt given by the
importer to the bank who has loaned"
• The advantages of field warehousing are several:
1. It is economical
2. Banks are more willing to quote a lower rate of interest on
loans secured by warehouse receipts.
3. If the manufacturer cannot be supplied with funds locally
paper secured by field warehouse receipt can be more ready
result in a nationwide commercial paper market.
 Factoring
- another type of institution arrangement for supplying short
term credit of business.
- the distinguishing feature of factoring is that accounts
receivable a bought outright rather than use as collateral for a
loan.
• Advantages of Factoring
1. It helps to eliminate the expense.
2. The client is able to do business for cash.
3. It provides money prior to the shipment and invoicing of
goods sold.
4. It provides advisory services marketing survey in management
and production counseling.
 Procedures - the contract or agreement between the factor and
the borrowing concern is generally in the form of a letter to the
borrower indicating the specific details of the arrangement.
 Short-term Borrowing by Means of Commercial Paper - is done
by raising funds from various financial institutions and other
investors.
 Briefly commercial paper - may be defined as "notes, drafts or
bills of exchange issued".
 The Securities and Exchange Commission - describes
commercial paper as an instrument evidencing and
indebtedness of any person or entity especially banks and land
banks performing quasi- bank.
 Sales of Commercial Papers in the Open Market
• A number of distinct advantages which are enjoyed by
businesses selling commercial paper in the open market may be
noted, such as:
1. The rate of discount is generally lower than the rate charge by
banks.
2. Often times, the need to maintain deposit balances of certain
specified amounts.
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3. Borrowers credit facilities are widened.
4. The prestige of the borrower becomes higher through such
sales due to advertising.
• However, there are also two shortcomings:
1. Buyers with whom the borrower does not have direct
relationships are relied upon.
2. Some degree of inconvenience through numerous inquiries
and investigations from banks and others.
 Promissory Notes - negotionable instruments which result from
business transactions requiring a comparatively short period of
time for their completion are termed as commercial paper.
• A promissory note in which the maker or drawer is responsible
for the payment of the obligation is termed as "a single name
paper, or one name paper"
• In such a case, the promisory note becomes a two name paper
that is, the second party becomes liable for the payment of the
loan obligation in the event of default on the part of the
principal that is, the maker of the instrument.
 Sale of Unsecured Promisory Notes
• Not in frequently a commercial paper containing the
endorsements of two or more individuals is called secured
paper.
•Such standing and repetition are the result of the following
favorable circumstances:
1. Continuous successful operation of the business for many
years
2. Prompt payment of obligations even more maturity
3. Current financial standing in healthy state
4. Excellent reputation and goodwill as a result of their
production and/ or distribution of goods of acceptable standard
and quality.
 Sales Finance Companies
• With the rapid rise in the volume of installment selling of
durable consumers goods, the role of the finance company in
financing such sales has grown accordingly.
• Sales finance companies by this contracts from the dealer and
collect the payments as they fall due.
• Three bases of purchase of consumer installment contracts
are generally observed namely non-recourse, full recourse and
repurchase.
1. Full recourse - frequently used in the purchase of installment
paper the dealer assumes all risks.
2. Repurchase - is the most common basis of purchasing
installment contract s for automobiles.
• Wholesale or floor plan - the finance company also assist the
dealer in carrying the automobiles which he keeps in stock.
CHAPTER 6: INTERMEDIATE-TERM FINANCING
 Intermediate financing is different from short term credit with
respect to its use and mode of payment. It is employed primarily
for the acquisition of fixed assets and relatively permanent
additions to working capital. It is customarily retired through:
1. Re-investment of earnings
2. Recovery of depreciation
3. Refinancing or a combination of these methods
 Payment of principal is seldom made as a lump sum at maturity
but is most often amortized over the life of the loan.
 Use and Distinctive Features
• Intermediate credit sometimes called the term loan, with a
maturity ranging from one to fifteen years.
• Term loan - it is likely to be amortized
• Long-term loans - generally retired through the use of sinking
funds.
 INVESTIGATION AND APPRAISAL OF APPLICATION
Risks to lenders increase substantially as the maturity of loans is
extended. For this very reason, careful investigation and
appraisal of the loan application is conducted, as is done in
commercial banks.
• The investigation and appraisal of the term loan follows more
or less the general procedures observed by the commercial
banks in the case of short term financing and emphasis is
focused on the following:
1. Condition of the business - Since term loans are amortized
through a combination of depreciation recoveries and
reinvested earnings, an analysis of the borrowing firm on the
stability of its earning power is necessary. In addition, the cash
flows must be of sufficient amount to insure the periodic
repayments of principal and interest and also provide the
working capital necessary for its continuous operations.
2. Quality of management - Success of operations among others
is closely related to the skill that characterizes management,
apart, of course, from the competitive position of the firm as
well as the character of the entire organization.
3. Risks - In most type of loans, there are risks involved. Most
often, risks associated with a business loan tend to vary directly
with the length of time to maturity. The longer the maturity of
the loan, the greater the risk to the lender. For his protection,
the common practice of lenders is to require the borrower to up
collateral security with adequate safety margins.
4. Reputation of the firm - The reputation of the borrower is an
important matter to consider. Good reputation is not only the
result of continuous years of existence but is circumscribed by
the conduct of its operations and fair dealings. A firm enjoying
goodwill will always endeavor to keep its good reputation as
much as possible. It will refrain from engaging in unethical
practices and meets its financial obligations promptly and
diligently.
5. Size of the business - Large enterprises with financial strength
are able to withstand economic thunderstorms better than with
an inadequate financial base. Firms in that unfortunate
circumstance may not be able to keep up with economic
changes and therefore may eventually decide to full up.
6. Kind of business - A firm that is engaged in the production of
consumer goods is vulnerable to changes in consumer tastes,
preferences and demands. Inability to meet such changes could
throw the enterprise helter skelter and make it slide down the
hill.
 Protective Covenants in Term of Loans
• Although the specific provisions of a term loan agreement are
flexible, they customatily impose a group of positive
requirements and negative restrictions on the debtor. The more
risky the financial position of the borrower, the greater the
number of limitations on which a lender will insist. Conversely,
the more the supply of loanable funds the fewer the restrictions
the borrower will accept. The more important provisions
include:
1. Maturity and installments - Although term loans made by
commercial banks run for as long as ten years, there are a
greater majority that are due within a five year period. The
smaller the borrower, the smaller the loan and the shorter the
term of the loan.
2. Security - While term loans may be unsecured, a lien is more
common than the normal commercial loan. Such security usually
depends on the use of borrowed funds. The term loan is
intended for the purchase of specific equipment. A lien on that
asset may be given and an attempt made to arrange
amortization so that the earnings derived from its operation will
"pay off the loan and the recovery value of the asset will remain
in excess of the loan balance.
3. Protective provision - The agreement to amortize a loan is
itself a protective provision. Because the term loan contract runs
for more than one year, it usually includes restrictive covenants
against acts or policies that might weaken the borrower's
position to repay his obligations.
• The more common provisions are:
a. Borrowers must agree to maintain working capital of at least a
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specified minimum size and keep the current and acid test ratios expensive than ownership of the same property.
up to certain standard • Financing is provided by the lesson and issuance of securities
b. Restrictions on dividends or redemption of collateral's that and the cost of underwriting a public offering or the payment of
will tend to reduce networking capital below specified minimum a "finder's fee" to an investment banker for obtaining a private
or below a certain percentage of total debt or that will diminish placement are unnecessary
network below on certain amount.
c. Restrictions and expenditures for fixed assets and excess of a
stipulated amount.
d. Prohibition of the pledging or mortgaging of assets to secure
other debts.
e. Prohibition of any merger, consolidation, sale or lease of
substantially all assets.
f. Adequate maintenance in insurance of property.
 Industrial Equipment Installment Financing
•Equipment installment financing is used primarily by the
smaller manufacturers who lack adequate-equity financing or
find it difficult to obtain unsecured credit. Among the types of
equipment financed on the installment basis are hotels,
restaurants, bars, store fixtures, barber shops and beauty parlor
equipment, devices used in commercial refrigeration, cleaning
and laundry equipment, machine tools and others.
 Equipment financing
•Equipment financing is very similar to consumer financing of
automobiles and other durable consumer goods. The owner of
small businesses may go to the consumer or personal loan
department of a bank to request the financing of their needs.
•Industrial equipment is purchased for purposes of generating
income for the company which represents the very source of
repayment of the loan obligations.
• The type equipment financed by installments is durable in
character and movable.
• Equipment installment paper requires a down payment, which
is usually with- in the range of 20% to 33-1/3%.
• The repayment period is based upon the cost of the fixture, its
expected service life and the credit of the buyer.
• Contracts are usually payable in regular monthly installments
and seldom go beyond thirty-six months except in the case of
manufacturing machinery.
• Sales finance companies on the other hand, purchase
equipment installment paper in the form of conditional sales
contracts directly from the manufacturer or distributor,
advancing an agreed percentage of the face value of the paper,
with recourse, or advancing funds to the ultimate buyer through
a loan secured by the equipment.
 Equipment leasing
• The industrial leasing company is prepared to supply a wide
variety of equipment needs.
• In a rental agreement the user pays rent only as long as he
wants to use the property and is not obligated to make
payments beyond-some-nominal period, say ninety days.
• The leasing of equipment enjoys a number of distinct
advantages over that of direct installment buying or the use of
equipment loans. They are:
1. Equipment can be obtained as needed.
2. The user is spared from the risk and problem of owning
equipment that is subject to paid obsolescence.
3. Under certain contracts, the leasing company agrees to
replace equipment, which may have broken down through use,
with a new one.
 Economic considerations
Briefly stated, it is useful as well as necessary to make a
thorough evaluation of the two competing methods. Two
questions must be considered and answered, which have an
important bearing on any business decision, the company may
make. For instance: Which is the more profitable of two
competing proposals?
 Cost of leasing
• For an enterprise that is free to choose its methods of
financing, the long-term leasing assets is generally more