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Module 1
Introduction to Business Finance
Welcome to the first module of Business Finance. Are you excited to
learn things about finance? Let’s first tackle the basic concepts.
In this lesson you should be able to
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Explain the major role of financial management and the
different individuals involved
Enumerate the various functions of the Financial Manager
Compare and contrast the basic types of financial instruments
Distinguish a financial institution from financial market
Classify institutions as banking and non-banking financial
institutions
Enumerate and distinguish the different types of financial
institutions and financial markets
Explain the flow of funds
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1.1 Definition of Business Finance
Finance is the art and science that describes the management, creation
and study of money, banking, credit, investments, assets and liabilities.
Finance is needed in business because financing decisions often
involve large financial amounts that are very significant to the business
and once made, such decision is not easily reversed. Financial
management decision function includes areas such as investment,
financing, and asset management decisions.
1.2 Objectives of Financial Management
The goals of business finance may be broadly divided into two parts
which includes profit maximization and wealth maximization.
Profit Maximization
The main aim of any kind of economic activity is to earn profit. When
we say profit, we usually refer to the financial benefit that is realized
when the amount of revenue gained from a business activity exceeds
the expenses, costs and taxes needed to sustain the activity. Profit
maximization is a traditional and narrow approach where business
entities determine the best output and price levels in order to maximize
its return. The company will usually adjust influential factors such as
production costs, sale prices, and output levels as a way of reaching
its profit goal.
Wealth Maximization
Wealth maximization is a modern concept which deals with the
increase of the value of a business in order to increase the share of
stockholders or the owners. It is widely accepted as the ultimate goal
of a business. The concept requires the management team to
continually search for the highest possible returns on funds invested in
the business, while mitigating any associated risk of loss. This calls for
a detailed analysis of the cash flows associated with each prospective
investment, as well as constant attention to the strategic direction of
the organization.
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1.3 Key Individuals in Business Finance
In a typical business organization, there are three key role players in
financial management. They are the financial manager, the controller
and the treasurer.
Financial Manager- he is in charge of the overall finance functions of a
business. He develops strategies and plans to achieve the
financial goals of the organization. In large companies, this position is
usually termed as Chief Financial Officer. The financial manager is to
whom the controller and the treasurer reports.
Controller – he is the one responsible for managing the accounting
staff that provides managerial accounting information used for internal
decision making, financial accounting information for external
reporting purposes, and tax accounting information to meet tax filing
requirements. The controller is usually the head accountant of the
company.
Treasurer- his primary duties include asset safekeeping and cash
management. He is also responsible for obtaining investment capital
as well as obtaining loans and credit from outside sources.
1.4 Functions of Financial Manager
The finance manager plays a very big role in the finance function
which requires him to have possessed knowledge in the area of
accounting, finance, economics and management. He is responsible
for the performance of the accountant and the treasurer since he is the
head of that department. His position is highly critical and analytical
to solve various problems related to finance. He performs the
following major functions
Forecasting Financial Requirements
The financial manager is responsible to estimate the financial
requirement of the business. He the one who should estimate how
much resources are required to acquire fixed assets and forecast the
amount needed in order to have a continuous business operation.
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Acquiring Necessary Capital
Financial managers are also in charge of the acquisition of the
necessary capital to be used in the business. He should concentrate on
how, where and when to obtain finances.
Investment Decision
The finance manager must carefully select best investment alternatives
and consider the reasonable and stable return from the investment. He
must be well versed in the field of capital budgeting techniques to
determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability
while investing capital.
Cash Management
The financial manager must see to it that the entity has enough cash
for its business operations as well as for the payment of debts or
liabilities. Furthermore this deals with the proper management of cash
on hand and cash in bank.
Interrelation with Other Departments
The finance manager must maintain a good relationship with all the
functional departments of the business organization. He should have
sound knowledge not only in finance related area but also in other
areas as well.
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1.5 The Financial System
Financial System is a framework which collectively describes the
financial markets, financial institutions, borrowers and lenders within
the economy. The functions of the financial system is to channel the
funds from lenders to the borrowers, provide a medium of exchange,
provide a mechanism for risk sharing and provide a channel through
which the central bank can influence the economy.
Financial Instruments
These things are crucial to the operation of the economy. A financial
instrument is the written legal obligation of one party to transfer a
thing of value, usually money, to another party at some future date,
under certain conditions. According to the Philippine Accounting
Standards 32, a financial instrument is any contract that gives rise to
both a financial asset of one entity and a financial liability or equity
instrument of another entity. With this definition, we can also
consider currency bills and coins as financial instruments because they
are financial assets of the person holding the money and a financial
liability of the government issuing it. In business, when we say
financial instruments, we basically refer to stocks bonds and notes.
Stocks
This is a type of security that signifies ownership in a corporation and
represents a claim on part of the corporation's assets and earnings.
Stocks are issued by companies in order to raise funds for the business.
Generally, this can be classified as common and preferred stock. This
is a financial asset of the stockholder and an equity instrument of the
issuing company.
Bonds
A bond is a debt security in which an investor lends his money to an
entity which borrows the funds for a defined period of time at defined
interest rate. Bonds are usually issued by companies, municipalities,
states and sovereign governments to raise money and finance their
economic activities. A bond is a financial asset of the investor –
reflected as Bonds Receivable and a financial liability of the issuing
company –reflected as Bonds-Payable.
Notes
This is a debt security obligating repayment of a loan with a
corresponding interest within a defined period of time. Notes are being
issued by the borrower to signify its indebtedness. A note is the
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financial liability of the debtor - reflected as Notes Payable and a
financial asset of the creditor - reflected as Notes Receivable.
Financial Markets
A financial market is where stocks, bonds and other financial
securities can be purchased or sold. Funds are transferred in financial
markets when one party purchases financial assets previously held by
another party. Financial markets facilitate the flow of funds and
thereby allow financing and investing by households, firms, and
government agencies.
Financial markets may be classified into two namely the money
market and the capital market. The money market is where debt
securities with an original maturity of one year or less are traded as
well as long-term securities having at least six months left to maturity.
The capital market is where securities with maturity of more than one
year are traded. The capital market is subdivided into bond market,
stock market and mortgage market.
Some financial markets may exist but have few activities. In the
country, the large financial markets are those being regulated by the
Banko Sentral ng Pilipinas. These are the foreign exchange market,
the fixed income exchange market and the stock market. The BSP
upholds and maintains the efficient and safe operations of these
financial markets.
Foreign Exchange Market
In the country, the Foreign Exchange is where participants can be able
to buy, sell, exchange and speculate on currencies. The BSP maintains
a floating exchange rate system. Exchange rates are determined on the
basis of supply and demand in the foreign exchange market. The role
of the BSP in the foreign exchange market is principally to ensure
orderly conditions in the market. The market-determination of the
exchange rate is consistent with the Government’s commitment to
market-oriented reforms and outward-looking strategies of achieving
competitiveness through price stability and efficiency.
Fixed Income Exchange Market
The Fixed Income Exchange is the country’s first centralized
electronic infrastructure for trading of fixed-income securities. The
FIE is a comprehensive financial market infrastructure that aims to
provide an electronic platform for trading, clearing and settlement, and
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depository and custodianship fixed-income securities and its
derivatives. When we say fixed-income securities, these are
investments that provide return in the form of fixed
periodic payments and the eventual return of principal at maturity.
This may include treasury bonds and certificate of deposits.
Stock Market
The Philippine Stock Exchange (PSE) is a private organization created
to provide and maintain a fair, efficient, transparent and orderly market
for the purchase and sale of stocks and other securities.
Financial Intermediaries
A financial intermediary is an entity that acts as the middleman
between two parties in a financial transaction. Financial
intermediaries are businesses which move money from the individual
into the markets. With this statement, we can say that those who are
borrowing in financial intermediaries are said to be engaged in indirect
financing. Financial institutions are considered as the financial
intermediaries.
A financial institution is an establishment that provides financial
services such as investments, loans and deposits. Typically, these are
the key entities that control the flow of money in the economy.
Financial institutions may either be a banking institution or nonbanking institution.
Banking Institutions
A bank is a financial institution that accepts deposits from the public
and creates credit which is being supervised by a regulatory agency.
Commercial Bank
This is a financial institution that provides various financial services,
such as accepting deposits, offering savings and checking account
services, and issuing loans for both private individuals and businesses.
Furthermore, it may also provide safety deposit boxes, mortgages,
debit and credit cards, automated teller machines, online banking and
other financial services. A commercial bank also has the power to
accept drafts and issue letters of credit; discount and negotiate
promissory notes, drafts, bills of exchange, and other evidences of
debt; accept or create demand deposits; receive other types of deposits
and deposit substitutes; buy and sell foreign exchange and gold or
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silver bullion; acquire marketable bonds and other debt securities; and
extend credit.
Investment Banks
Unlike commercial banks, investment banks do not take deposits.
Their focus is assisting individuals, corporations, and governments in
raising capital by underwriting or acting as the client's agent in the
issuance of securities. An investment bank may also assist companies
involved in mergers and acquisitions.
Non-Banking Financial Institutions
A non-banking financial institution is a financial institution that does
not have a full banking license or is not supervised by a national or
international banking regulatory agency.
Credit Unions
These are non-profit financial cooperatives owned by and operated for
the benefit of its members. These member-owned financial
cooperatives are democratically controlled by its members, and
operated for the purpose of offering its members economical financial
services. Membership is available through affiliation with an
employer, a union, religious organization, community organization, or
some other group.
Savings and Loan Associations
These are also known as thrift banks, these are financial institutions
that specialize in savings type deposits, mortgages and other loans.
They provide dividends to their depositors. Today savings and loan
associations offer most of the services commercial banks do. They can
also serve both consumers and businesses. However, by law, they can
have no more than twenty percent of their lending in commercial
loans.
Insurance Companies
These are corporate entities that insure people against loss. The client
pays a fee, known as a premium, in exchange for the promise of the
company to protect the client financially in the event of certain
potential misfortunes. The common types of insurance include health,
life and property insurances.
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1.6 Flow of Funds
The figure below shows how the funds flow from the participants in
the financial system. As you can see we have the direct and the
indirect finance.
In indirect finance, a financial institution stands between lender and
borrower. For example, a bank receives money from its savers or
depositors. The bank has now the money on hand. Then, a spender
decides to borrow funds from the bank to buy a car. The bank lends
out the money of the saver to a borrower.
In direct finance, the borrowers sell securities directly to lenders in the
financial markets. There are no intermediaries involved. For example
a corporation offers its stocks to the stock exchange and the investor
acquires it by paying the required amount. In exchange of the
corporation issues a stock certificate to the investor which is now
considered as the stockholder.
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Glossary
Financial Manager- the one in charge of all the organization’s finance and
accounting functions and typically reports to the chief executive officer.
Controller –the one responsible for managing the accounting staff that
provides managerial accounting information used for internal decision
making, financial accounting information for external reporting purposes,
and tax accounting information to meet tax filing requirements.
Finance - is the art and science that describes the management, creation and
study of money, banking, credit, investments, assets and liabilities
Financial institution is an establishment that provides financial services such
as investments, loans and deposits.
Financial market – this is where financial securities such as stocks and bonds
can be purchased or sold.
Financial system - a framework for describing set of markets, organizations,
and individuals that engage in the transaction of financial instruments, as
well as regulatory institutions.
Profit – the difference between income and expenses
Treasurer- the one responsible for obtaining sources of financing for the
organization, projecting cash flow needs, and managing cash and short-term
investments.
Wealth – the true value or net worth of business
References
C. Paramasivan and T. Subramanian. (2005). “Financial
Management”, New Age International Ltd., Publishers.
J. Van Horne and J. Wachowics (2008). “Fundamentals of Financial
Management”, Pearson Education Limited.
Investopedia, (2016).
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Supplemental Resources
Videos
The American Dream (2011), “Understanding Money and the Banking
System”, https://www.youtube.com/watch?v=k6zpfE7WjHI
Oracle (2015). “Modern Finance in Digital Age”
https://www.youtube.com/watch?v=saijnZMQueo
Oracle (2015). “A Day in the Life of A Modern CFO”,
https://www.youtube.com/watch?v=X-U9RTt4x-o
Online Readings
Investopedia (2016). “Finance”.
http://www.investopedia.com/terms/f/finance.asp
S. Chand (2015). “Difference Between Profit Maximization and
Wealth Maximization”,
http://www.yourarticlelibrary.com/difference/difference-betweenprofit-maximization-and-wealth-maximization-financialmanagement/29378/
Investopedia (2015). “Types Of Financial Institutions And Their
Roles”, http://www.investopedia.com/walkthrough/corporatefinance/1/financial-institutions.aspx
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