Business Finance: Unit 1 - Introduction to Financial Management

Chapter 1: Overview to Financial Management

Definition of Finance
- Finance is defined as a body of facts, principles, and theories relating to the raising and using of money by individuals, businesses, and governments.
- It encompasses the methods by which people and organizations raise and allocate capital and use monetary resources.
- It involves accounting for the risks inherent in financial activities.
- It is the study of valuation for various entities and assets, including:
  - Valuation of a business enterprise.
  - Calculation of payments remaining on a property mortgage.
  - The purchase of an entire company.
  - Personal financial decisions, such as early retirement planning.
Subfields of Finance
- The study of corporate finance or financial management.
- The study of investments.
- The study of financial institutions and markets.
The Financial Management Process
- This process consists of three major functions: a. Financial analysis and planning. b. Utilization of funds. c. Acquisition of funds from investors.
- Specifically, financial management involves decisions regarding:
  - Organizing the firm to attract capital effectively.
  - Determining how capital should be raised, specifically through debt or equity.
  - Selecting which projects to fund.
  - Allocating and managing both long-term and short-term resources.
  - Minimizing taxation burdens.
The Study of Investments
- This subfield involves the methods and techniques for making appropriate decisions regarding:
  - The specific kinds of securities to own.
  - Which firms' securities to purchase.
  - How to pay an investor back in the specific form the investor desires.
Financial Institutions and Markets
- These entities facilitate capital flows between investors and companies.
- This area involves the initial acquisition of capital by firms and the subsequent ongoing trading of securities by investors.

Financial Management and its Objectives

Definition of Financial Management
- Financial management is also referred to as:
  - Managerial finance.
  - Corporate finance.
  - Business finance.
- It is a decision-making process concerned with planning, acquiring, and utilizing funds to achieve the firm's desired goals.
- It is a subset of the larger discipline of finance.
- While the procurement of funds on the best terms is central, the function is broader than just supply; it involves total resource management.
Objective of Financial Management
- The primary goal is to maximize the current value of ownership in a business firm.
- This objective recognizes that residual owners are entitled only to what remains after all other legitimate claims are paid.
- Legitimate claimants that must be paid first include:
  - Employees.
  - Suppliers.
  - Creditors.
Significance of Financial Management
- Applicability: Essential for all types of businesses.
- Chances of Failure: Effective management reduces the risk of business collapse.
- Return on Investment: Focused on optimizing the returns generated on capital.
Scope of Financial Management
- Traditional Approach:
  - Procurement of short-term and long-term funds from financial institutions.
  - Mobilization of funds via instruments like equity shares, preference shares, and debentures.
  - Compliance with legal and regulatory provisions regarding fund procurement, distribution, and use.
- Modern Approach:
  - Determining the total funds requirements of the firm.
  - Identifying the specific assets or resources to be acquired.
  - Determining the best pattern of financing those assets.

Chapter 2: Role of the Finance Manager

Primary Responsibility
- The finance manager strives to maximize owner or shareholder wealth.
- This involves making decisions regarding planning, acquiring, and utilizing funds.
- These decisions require managing risk-return trade-offs.
- Financial decisions impact the market value of the firm's equity shares, which is the mechanism for wealth maximization.
Decision Flowchart Factors
- Analysis and Planning.
- Acquisition of Funds.
- Utilization of Funds.
- Impact on Risk and Return.
- Effect on Market Value of the Business Firm.
- Result: Shareholder's Wealth Maximization.
The Finance Organization
- Organization varies by business size:
  - Small Business: The President or General Manager assumes direct responsibility for all functions: marketing, production, finance, human resources, and security.
  - Medium-size Business: A separate department usually exists, headed by a Finance Manager whose primary responsibility may be the supply of funds.
  - Specific Division of Roles: In some firms, broad financial responsibilities are split between a Treasurer and a Controller.
  - Large Concerns: Both the Treasurer and the Controller report to a Chief Financial Officer (CFO), often holding the title of Vice-President – Finance.
Relationship with Other Functional Managers
- Finance is one of the major functional areas alongside Manufacturing and Marketing.
- Manufacturing: Focuses on design and production.
- Marketing: Focuses on selling, promotion, and distribution.
- While manufacturing and marketing are critical for survival (determining what to produce and how to sell), finance is an integral part of management that cuts across all functional boundaries.

Specific Types of Financial Decisions

1. Investment Decisions
- Determine how limited funds are committed to specific projects.
- Involves allocating funds wisely among alternative uses.
- Requires managing the asset mix (the ratio of current assets to fixed assets).
- Assets should only be acquired if they earn a return greater than the minimum acceptable return, known as the hurdle rate.
- Examples of Investing Decisions:
  - Funds allocation and rationing.
  - Determining the total amount of investable funds.
  - Evaluation and selection of capital investment proposals.
  - Prioritization of investment alternatives.
  - Determining levels of investment in working capital.
  - Acquisition of fixed assets.
  - Asset replacement decisions.
  - Purchase or lease decisions.
  - Restructuring, reorganization, mergers, and acquisitions.
  - Securities analysis and portfolio management.
2. Financing Decisions
- Focus on the mix of debt and equity used to finance investments to maximize investment value.
- Considers the cost of available finance and its associated risks.
- Requires knowledge of the costs of raising funds and risk hedging procedures.
- Involves understanding various financial instruments and their attached obligations.
3. Operating Decisions
- Concerns working capital management, specifically short-term assets and liabilities.
- Short-term Assets: Inventory, receivables, cash, and short-term investments.
- Short-term Liabilities: Accounts payable, short-term loans.
- Involves managing cash receipts and disbursements.
- Key Issues Includes:
  - Determining the specific levels of cash, securities, and inventory to keep on hand.
  - Setting credit policy (selling on credit and establishing terms).
  - Identifying sources of short-term financing.
  - Deciding whether to purchase materials on credit or use short-term loans for cash payments.
4. Return of Capital Decisions
- Concerns dividend distribution to corporate owners.
- Determines the quantum (total amount) of profits to be distributed, frequency of payments, and the amount to be retained by the firm.

Chapter 3: Financial Environment and Business Organization

The Organization of the Business Firm
- A firm is an entity designed to organize raw materials, labor, and machines to produce goods or services.
- Basic activities include:
  - Purchasing productive resources from households and other firms.
  - Transforming resources into different commodities.
  - Selling the transformed products/services to consumers.
A. Sole Proprietorship
- Owned by a single person with complete control over decisions.
- Owner owns all assets and is responsible for all liabilities.
- Legal Status: The owner is not legally separable from the business; they are personally liable for all business debts.
- Accounting Status: Viewed as an entity separate from the owner; financial statements only show business assets and liabilities.
- Advantages:
  - Ease of entry and exit (no formal charter, inexpensive).
  - Full ownership and control of all profits and losses.
  - Tax savings (income passes directly to the owner).
  - Minimal government regulation.
- Disadvantages:
  - Unlimited liability (personal assets at risk for business debts).
  - Limitations in raising capital (limited to owner’s assets and borrowing ability).
  - Lack of continuity (business ceases upon the owner's death or retirement).
- Financial Statement Presentation:
  - Listed in the ‘Owner’s Equity’ section as: $\text{Jose del Pilar, Capital}$ .
B. Partnership
- A legal arrangement where two or more persons contribute capital or services and divide profits and losses.
- May be established via a written partnership agreement filed with the Securities and Exchange Commission (SEC).
- General Partnership: Each partner has unlimited liability for business debts.
- Limited Partnership: Contains at least one general partner and one or more limited partners.
- Advantages:
  - Ease of formation (low start-up costs).
  - Additional sources of capital (combined resources of several people).
  - Broader management base and expertise.
  - Tax implications (The partnership itself pays no income tax; income/loss is reported on partners' personal tax returns).
- Disadvantages:
  - Unlimited Liability for general partners.
  - Lack of continuity (dissolves upon withdrawal/death of a general partner).
  - Difficulty of transferring ownership (liquidation is difficult).
  - Limitations in raising very large amounts of capital compared to corporations.
- Financial Statement Presentation:
  - Listed as: $\text{Jose del Pilar, Capital}$ and $\text{Marcelo de Guzman, Capital}$ .
C. Corporation
- An artificial being created by law; a legal entity separate from its owners.
- Can own assets and borrow money independently.
- Owners (shareholders) elect a Board of Directors to manage the firm.
- Requires filing Articles of Incorporation with the SEC.
- Advantages:
  - Limited liability (shareholders only lose their investment in shares).
  - Unlimited life (continuing existence regardless of owner status).
  - Ease in transferring ownership (selling stocks).
  - High ability to raise capital via bonds (debt) or common stock (equity).
- Disadvantages:
  - High time and cost of formation.
  - Heavy regulation (government oversight; restricted asset withdrawal).
  - Taxes (corporations pay tax on earned income).
- Financial Statement Presentation:
  - Shareholders’ Equity section includes Ordinary Shares (e.g., $P100$ par value), Additional Paid-in Capital, and Retained Earnings.

Financial Markets

Definition and Participants
- Meeting place for those who need money and those with money to lend or invest.
- Participants include people, corporations, national/state/local governments.
- Markets for government funds are "public financial markets."
- Markets for large corporations are "corporate financial markets."
Primary vs. Secondary Markets
- Primary Market:
  - The original sale of securities by governments and corporations.
  - The transaction raises money for the issuer.
  - Includes public offerings and private placements.
- Secondary Market:
  - Popularly known as the Stock Market or Exchange.
  - Assets are traded between investors after the initial issue.
  - Organized Stock Exchange: Physical location (floor) for buying/selling.
  - Over-the-Counter (OTC) Exchange: Trading via computer screens and telephones for shares, bonds, and money market instruments.
Specific Market Types
1. Physical Asset Markets vs. Financial Asset Markets: Physical deals with tangible products (wheat, real estate, machinery); Financial deals with stocks, bonds, notes, and mortgages.
2. Spot Markets vs. Future Markets: Spot involves "on-the-spot" delivery; Future involves contracts to buy/sell at a specific future time.
3. Money Markets vs. Capital Markets: Money markets are for short-term funds (less than $1$ year); Capital markets are for stocks and long-term debt ( $1$ year or longer).
4. Private Markets vs. Public Markets: Private involves direct transactions between two parties; Public involves standardized contracts on organized exchanges.

Financial Institutions

Categories of Institutions
1. Investment Banks: Underwrite/distribute new securities.
2. Commercial Banks: Traditional "department store of finance" for diverse savers/borrowers.
3. Financial Services Corporation: Offers investment banking, brokerage, insurance, and commercial banking.
4. Credit Unions: Cooperatives for members with a common bond (e.g., same employer).
5. Pension Funds: Handle retirement plans funded by corporations or government agencies.
6. Life Insurance Companies: Invest annual premiums in stocks, bonds, and real estate.
7. Mutual Funds: Pool investor funds to reduce risk via diversification.
8. Exchange Traded Funds (ETF): Similar to mutual funds but often operated by mutual fund companies.
9. Hedge Funds: Accept money to buy securities but differ from mutual funds (often less regulated).
10. Private Equity Companies: Buy and manage entire firms rather than just purchasing shares.
Banking Market in the Philippines
- Commercial and universal banks account for almost $90\%$ of the banking system's combined assets.
- As of $\text{February 2017}$ statistics:
  - Universal Banks: More than $25$ .
  - Commercial Banks: More than $25$ .
  - Thrift Banks: More than $80$ .
  - Rural Banks: More than $650$ .
Structure of the Philippine Financial System
- Bangko Sentral ng Pilipinas (Central Bank)
- Private Banking Institutions: Universal, Commercial, Thrift (Savings/Mortgage, Stock Savings/Loan, Private Development), Rural, and Cooperative Banks.
- Private Non-Bank Institutions: Investment Houses, Financing Companies, Pawnshops, Credit Unions, Securities Dealers, Trust Companies, Insurance Companies, etc.
- Government Banking Institutions: Development Bank of the Philippines (DBP), Land Bank of the Philippines, Al-Amanah Islamic Investment Bank.
- Government Non-Bank Institutions: GSIS, SSS, PAG-IBIG.