FM 101 REVIEWER

CHAPTER 1: to enable the business to meet possible contingencies. -

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