Business Finance

MODULE 2: FINANCIAL INTERMEDIATION AND

THE SOURCES AND USES OF SHORT-TERM AND
LONG-TERM FUNDS

Learning Competencies:

1. Know the concept of financial intermediation and identify the different

financial intermediaries

2. Understand the role financial intermediaries play in socio-economic

development.

3. Identify the different sources of short-term and long-term financing.

4. Differentiate debt financing from equity financing.

5. Know the obligations of borrowers to their creditors.

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I FINANCIAL INTERMEDIATION

Financial intermediation is the bridge that enables the meeting of

household investors, savers or surplus units and the borrowers, business
investors, security issuers or the deficit units.

In the illustration above, the bank is what we call the financial

intermediary. It receives money from the household who is presently
experiencing surplus funds and so decides to open a deposit account
with the bank. These could be in the form of savings account, checking
account, time deposit and money market placement. In this case, the
household is the lender, and the bank is the borrower. The relationship of
or the transaction between the household and the bank is what we call
direct finance because the deposit in essence, is a loan by the depositor
to the bank who in turn will use the deposit to relend to other borrowers.
The depositor is the surplus unit, and the bank is the deficit unit.

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When the bank pooled all deposits received and relends them to
borrowers, it is now acting as a financial intermediary between the
depositors who are the surplus units and the borrowers from the bank who
are the deficit units who now has an indirect relationship with the depositors,
thus the term indirect finance. However, the relationship between the
bank and its borrowers is also a form of direct finance where the bank
borrowers pay interest directly to the bank in payment for the use of money.
This process performed by banks of taking in funds from a depositor and
then lending them out to a borrower is what we call financial intermediation.
Borrowers do not need to contact the lenders directly. This process allows
banks to lend out money at relatively high rates of interest while receiving
money on deposit at relatively low rates of interest. In this way the banks
earn through the interest spread between what they pay to depositors and
what they collect from their borrowers. Example: The banks pays
depositors 5% per annum on deposits but charge borrowers 14% per annum
on loans. The lifeblood of the bank is the 9% interest spread.

Based on the above scenario, we may now define financial

intermediation as “a productive activity in which an institutional unit incurs
liabilities on its own account for the purpose of acquiring financial assets by
engaging in financial transactions on the market.” Financial
intermediation is distinct from other forms of business in the sense that their
assets and liabilities are overwhelmingly financial consisting of claims to
future cash and have a negligible amount of tangible assets. This is so
because financial intermediaries simply move funds from one sector with
surplus to another sector who is in deficit. Financial intermediaries issue
their own financial instruments which are considered as secondary
securities. Original issuers of securities like corporations which issue stocks
and bonds, issue what is termed as primary securities.

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Some of the advantages of having financial intermediaries include the

following:

a) Lower search costs: You do not have to find the right lenders; you
leave that to a specialist.
b) Spreading risk: Rather than lending to just one individual, you can
deposit money with a financial intermediary who
lends to a variety of borrowers — if one fails; you
will not lose all your funds.
c) Economies of scale: A bank can become efficient in collecting
deposits, and lending. This enables economies
of scale — lower average costs. If you had to
sort out your own saving, you might have to
spend a lot of time and effort to investigate best
ways to save and borrow.
d) Convenience of Amounts: If you want to borrow P100,000 — it
would be difficult to find someone who wanted
to lend exactly P100,000. But a bank may have
1,000 people depositing P100 each.

II CLASSIFICATION OF FINANCIAL INTERMEDIARIES

Financial intermediaries are classified into:

1. Depository Institutions – these are financial institutions that

accept deposits from the public like-
1a) Commercial Banks –
• Ordinary commercial banks perform the simpler
functions of accepting deposits and granting
loans. They do not have investment functions.
• Universal banks perform investment services in
addition to the regular deposit and loan

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functions. They invest in stocks and bonds of

non-allied businesses, thus are sometimes
called investment house. They are also
involved in securities transaction, underwriting,
financial analysis, payment processing and
other financial services.

1b) Thrift Banks – are engaged in accumulating savings of

depositors and investing them. They also provide working
capital, medium and long-term financing to businesses
engaged in agriculture, services, industry and housing,

diversified financial and allied services, and the financial

needs of small and medium enterprises and individuals.
Example:

• Savings and Mortgage Banks – are specializing

in granting mortgage loans in addition to
accepting deposits.
• Private Development banks – cater to the
needs of agriculture and industry with
reasonable rate loans for medium and long-
term purposes.
• Savings and Loan Associations – accumulate
savings from their depositors and use these with
their capital for loans to members and
investments in government and private
securities.
• Microfinance Thrift Banks – cater to small, micro
and cottage industries; grant small loans to sari-
sari stores, bakeries, cottage industries usually in
rural areas.
• Credit Unions – are cooperatives organized by
people from the same organization like farmers,
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employees, teachers and grant loans to

members from their deposits.

1c) Rural Banks – are geared towards the development of the

countryside. Their role is to promote and expand the rural
economy by providing people in rural communities with basic
financial services.

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2. Non-depository institutions – issue contracts as sources of funds,

unlike the depository institutions which accept deposits as
sources of funds. Examples:
2a) Insurance Companies – issue contracts for future
payments under certain specified conditions.
Business Finance
2b) Finance Companies – sells marketable securities and lend
to individuals and firms
2c) Mutual Funds – issue shares in a portfolio of securities
2d) Pension Funds – like insurance companies, also issue
contracts for future payments under certain specified
conditions.
2e) Investment Banks – underwrite new issues of equity and
debt securities.

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III RISKS OF FINANCIAL INTERMEDIATION

The risk in financial intermediation is the possibility that actual returns

differ significantly from what is expected. Buying securities at a time when
prices go up has no guarantee of gaining precisely because prices do go
up but, they also go down. If prices continue to go up, there will be gains,
but when prices go down there will be losses. Financial intermediation is
largely dependent on market performance as such it faces several risks:

1. Interest rate/Market value risk – this is the risk that the market
value of an asset will decline when interest rate goes up, resulting
in a capital loss when sold. This is so because securities decline
in price when interest rates rise.
2. Default / Credit risk – is the risk that the borrower will be unable to
pay interest on a loan or the principal upon maturity.
3. Inflation / Purchasing power risk – is the risk of increase in the value
of goods and services in effect reducing the purchasing power
of the currency.
4. Political risk – is the risk that government laws and regulations
bring to the investor’s return on investment adversely or
negatively.
5. Liquidity risk – results from the withdrawal of funds by investors or
exercise of loan rights or credit lines of clients.
6. Currency or Foreign exchange risk – is the possible loss resulting in
the appreciation or devaluation of current exchange rate.

IV ROLE OF FINANCIAL INTERMEDIATION IN SOCIO-ECONOMIC

DEVELOPMENT

Financial intermediaries serve as the government’s instrument in

pursuing the goal of poverty alleviation most especially in the countryside.
By poverty alleviation we mean the activation of resources to promote
entrepreneurial pursuits, encourage engagement in various industries
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notably the micro and cottage industries, and motivate the rural folks to be
self-sufficient. With these objectives financial intermediaries make
available much needed funds from the urban areas to the rural areas
which are still in the present at the receiving end of vital assistance for the
people’s welfare and development.

In the field of agriculture which the Philippines is still in the predominant

stage, the intervention of micro finance for farmers are usually in the form
of assistance for seed and fertilizer procurement, equipment buying,
channeling of farm produce to the markets, and bridging the sales
proceeds of products even before they actually reach the market by
providing farmers with short-term loan assistance with the products as
collateral.

Micro finance also provides our fishermen with the means to carry out
their occupation like the supply of motorboats, fishing nets and short-term
advances for working capital start-up. Even the growth of small businesses
like sari-sari store, canteens and eateries, and the buy-and-sell trade are
made possible and are encouraged to flourish as a way of pushing
countryside development to new heights.

Financial intermediaries are also instrumental in securing funds for the

establishments of schools, emergency clinics, other important infrastructure
development. They also helped individuals pursue education, businesses,
and livelihood projects to attain economic independence.

V SOURCES OF FINANCING

The sources of financing are classified into two main categories:

1. Equity Financing - refers to the issuance of new issues of stocks
and the use of internally generated funds termed as retained
earnings for use in business operation. This is the safest and the
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least costly source of financing because the company involved

is not burdened with mandatory payments of dividends. It also
provides the company with financial flexibility because a low
leverage ratio is attractive to investors. When the time comes
that the company needs financing it has several options open: it
can raise funds through debt financing, equity financing, or a
combination of both.
Disadvantages of equity financing:
a) Cash dividends are not tax deductible
b) Cash dividends are not assured
c) Issuance of new shares may dilute ownership in terms of
percentage of existing stockholders
d) In case of liquidation, the creditors have to be satisfied first
before the stockholders
e) If the company does not perform well, the stockholders
absorb the losses.

2. Debt Financing - is in the form of borrowing from banks and other

financial institutions, the issuance of debt securities like
commercial papers and bonds, or as advances from
stockholders to facilitate raising of much needed funds. This form
of financing creates a contractual obligation for the borrower to
pay the interest and the principal upon maturity. There is also an
obligation on the part of the financial managers to limit the level
of borrowing because too much exposure can jeopardize the
credit rating of the company and at the same time risk
bankruptcy.
However, there are some benefits of this kind of financing:
a) Interest expense is tax-deductible
b) Debt financing can push expansion and growth
plans without diluting the interest of stockholders.
c) Creditors do not usually intervene in business
decisions.
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VI SOURCES AND USES OF SHORT-TERM FUNDS

Short-term funds are normally used in the day-to-day operation of the

business like funding working capital requirements in the form of inventory
build-up, the credit policy for accounts receivable levels and the need for
prepayments. Sometimes it is resorted to in paying current obligations of
the company.

The following are sources of short-term fund requirements:

1. Bank loans – in the form of credit lines, working capital loans, and
short-term borrowings. These usually require collaterals which will
have to be evaluated to determine loanable values. Collaterals
usually include real estate, transportation vehicles, other
equipment, and inventories.
2. Advances from stockholders – the easiest and the fastest way to
raise short-term fund requirements. Stockholders may charge
the company interest for the use of the money.
3. Suppliers’ credit – purchases of raw materials and inventories
may be financed by suppliers depending on the term agreed
upon which is called credit terms. These terms must be honored
so that a continuous credit arrangement is assured, and business
operation is guaranteed not to be disrupted.
4. Membership in credit cooperatives – loans can be as high as ten
times the equity if credit rating is observed to be favorable over
a considerable time.
5. Lending companies – are usually resorted to for working capital
funding. This arrangement usually carry a higher cost than banks.

NOTE: This topic will be discussed in more detail when we discuss

working capital management in subsequent modules.

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VII SOURCES AND USES OF LONG-TERM FUNDS

Long-term funds are used for capital investments like plant expansion,
new product development, purchase of equipment, purchase of land for
business use, research and development and building construction. The
reason for this kind of matching is that capital investment usually takes time
to realize expected returns and therefore requires a slow repayment
schedule to avoid inability to meet maturing obligations.

The following are sources of long-term fund requirements:

1. Equity investors - are those who purchase shares of stocks
for investment purposes.
2. Internally generated funds – these are the retained
earnings of the company that are set aside for such long-
term purposes as discussed in the preceding paragraph.
There is a provision of law prohibiting the retention of
company profits up to a certain percentage of paid-in
capital. However, the Board of Directors can always issue
a resolution setting aside a part of company earnings for
future development termed Restricted Retained Earnings.
This is considered not covered by the prohibition on
accumulated earnings.
3. Banks – always are prepared to grant long-term loans to
their clients with interest rates lower than other financing
institutions.

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Activity 1 and MT at the same time

a) Secure a list of requirements for loan application

from BDO and Metro Bank or any bank of your
choice.

b) Do a write-up on the loan application process for

the bank of your choice.

c) Enumerate and briefly explain the kinds of

financial services the bank offers.

4. Bonds - these are certificate of indebtedness issued by

corporations in need of a large amount of funding
requirement. Bonds have specific interest rates and
maturity dates. Most bonds are long-term, they mature in
more than a year.

5. Lending companies – there are certain instances when

lending companies which normally allow borrowing on a
short-term basis only, may opt to grant long-term loans to
selected clients with favorable credit ratings.

VIII RESPONSIBILITIES OF BORROWERS TO THEIR CREDITORS

It is easier to understand why a business experiencing losses may resort

to borrowing in order to survive. But, for a flourishing business to take on
debt for operational purposes is something difficult to understand for
people outside the business world. Borrowing and lending is at the heart
of business operations in these days and age. It is a respectable practice
in modern finance. In these times of steep competition companies selling
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goods and services act as creditors and debtors to each other.

Manufacturers mainly are creditors for distributors and retailers who
purchase products on credit for sale. At the same time, they are borrowers
from banks and other financial institutions to finance capital projects and
to fund working capital requirements that produce returns exceeding the
cost of borrowing.

In this credit economy, what is critical is that borrowers know their

obligations to their creditors.

• First and foremost is to pay obligations earlier or on due dates.

Making on-time payments is central to the act of borrowing.
• Credit Line limits must be observed at all times. In addition to
prompt payment, this is a commitment on the part of the
borrower as provided in the loan agreement.
• Pledged collateral must also be preserved responsibly as a
lien is attached to these assets to secure payment of the loan.
• All information in the loan agreement must be truthfully
declared, and any changes must be reported immediately
to the creditor.
• Should a difficulty arise in the payment of the loan,
negotiations must be initiated with the creditors for extensions
and possible remedial measures be instituted to guarantee
payment.
• The ultimate responsibility is to pay the entire amount of the
borrowing together with the corresponding cost

ACTIVITY RESULTS
Activity Score Remarks
1

Note to Parents or Guardians: Kindly check in the “Remarks” column when

the activity is accomplished.

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REFERENCES

Norma Dy Lopez-Mariano, Ph.D. (2014). Elements of Finance. Rex Bookstore,

Inc., Sampaloc, Manila.

Arthur S. Cayanan, Daniel Vincent H. Borja, (2017). Business Finance, Rex

Bookstore, Inc., Sampaloc, Manila.

https://www.business-case-analysis.com/creditor-debtor.html

Date Finished : __________________________________________

Parent’s Name & Signature: __________________________________________

“Wisdom is a reflection of eternal light, a spotless mirror of the

working of God, and an image of His goodness” (Wisdom 7:26)

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