LESSON 11 – FINANCIAL PLANNING TOOL AND CONCEPTS (PART II)

Objective – To explain tools in managing cash, receivables, and inventory.

Borrowed Capital

Capital acquired that gives rise to a liability (or debtor-creditor relationship) is

borrowed capital. Increases in liabilities are effected in a number of ways and some of
them are as follows:

⚫ Purchasing goods, property and equipment and availing of other parties’ services on
account or charge basis.
⚫ Obtaining loans from financing companies.
⚫ Receiving advances from officers and affiliate companies.
⚫ Issuing commercial papers.
⚫ Discounting notes receivable (or promissory notes received from customers and other
third parties).
⚫ Floating bonds.

When a business firm acquires goods or avail of other parties’ services on charge
basis, it is able to operate with smaller amount of equity capital specially when the short-
term liability arising there from is due or payable after the expected collection from sale
of the goods to purchased (in other words, collection period is longer than payment
period).

In periodic financial reports, liabilities are generally classified into current and long-
term. Current liabilities are those maturing within one year. Liabilities that will mature
beyond one year are classified as long-term debt.

In financial circles, loans are classified based on their terms into short-term, medium
and long-term. Short-term loans are those maturing within one year, medium (or
intermediate) loans are those maturing after one year up to within five year; and, long
term loans are those maturing beyond five years (up to 10,20 or more year).

Making use of borrowed capital is an example of financial leverage. The business is

willing to pay interest and other charges on borrowed capital with the intention of raising
the earnings per share on common stock.

Financial Leverage. The term leverage has been defined by Webster as “the
mechanical advantage of power gained by using a lever”. Lever, in turn, is defined as “a
bar or rigid piece”, rotating about a fixed axis or fulcrum, which lifts or sustains weight at
one point by means of applied force at a second point. Financial leverage, therefore,
refers to the financial advantage derived from having additional funds may be expressed
in terms of increased capacity to produce and sell, to create other sources of income, and
to take advantage of business opportunities as they arise, and the increased ability to
offset or meet possible losses or downtrend in economic activities.
 Cost of Borrowed Capital. Interest is paid on borrowed capital. In as much as it is
deductible for income tax purposes, the corresponding tax benefit is treated as
adjustment to interest expense in computing for the cost of borrowed capital. This cost is
therefore computed as follows:

Cost of borrowed capital = Interest x (1-tax rate)

Example: OMEGA Corp. Obtained a 20%, P200,000, one-year loan from MFF
Financing Company. Income tax rate is 35%. The cost of capital from this source is
computed as follows:

Cost of borrowed capital = 20% x (1-35%) = 13%

Proof:
Interest of 20% on P200,000 P40,000
Tax benefit (35% of P40,000) 14,000
Interest expense net of tax benefit P26,000

Percentage (P26,000/P200,000) 13%

Invested Capital vs. Borrowed Capital

In determining whether a business entity should have more of invested capital or

borrowed capital, the following differences should be considered:

a. Invested capital relatively permanent for it stays with the business until it is gradually
reduced by accumulated losses or until the business is dissolved. Borrowed capital has
its maturity date or requires periodic amortizations so that cash budgets should provide
for these periodic outlays.

b. Dividends are paid on invested capital while financing charges are paid on borrowed
capital. Dividends are not deductible for income tax purposes while financing charges
(interest expense and service charges) are deductible so that the latter five rise to tax
benefits while the former do not.

c. In managing the capital of a business, management tries to maximize earnings on

invested capital and minimize financing charges on borrowed capital.

d. Upon the dissolution of a business entity, invested capital is returned to owners after
the claims of third parties have been fully paid. In other words, creditors’ claims have
priority over owners in asset distribution in the liquidation process.

When the rate of return that can be realized from the use of borrowed capital is higher
than its cost, the use of borrowed capital, to a certain extent, is advisable.
 Example: MFF Co. is planning to undertake a certain project that will require
investment of P200,000 from which it expects to realize a 25% rate of return. Loans may
be obtained at the interest rate of 18% per annum. Income tax rate is 35%.

Cost of borrowed capital = 18% (1-35%) = 11.7%

Making use of borrowed capital in the proposed project would therefore result in an
incremental income of 13.3% (that is 25% rate of return from the project minus 11.7%
cost of borrowed capital).

If MFF Co. Is currently realizing a net income of P30,000 on invested capital of

P100,000 (divided into 10,000 shares of capital stock with par value of P10
each), the additional income from the project would raise the rate of return on owners’
equity from 30% to 56.6% and the earnings per share (EPS) from P3 to P5.66, computed
as follows:

From
At Present Proposed Project Total

Net income P 30,000 (P200,000x13.3%)=26,600 P56,600

Owners’ equity P 100,000 P100,000
Rate of return on
owner’ equity 30% 56.6%

Earnings per share (EPS)

P30,000/10,000shrs P3
P56,600/10,000shrs P 5.66

In the foregoing illustration, the owners’ equity remains at P100,000 despite the
additional resources made available for its use because they come from creditors. The
additional resources generate additional income thereby raising the rate of return on
owners’ equity and the earnings per share. They also raise the debt/equity ratio from 0:1
to 2:1 computed as follows:

At Present Per Proposal Total

Total liabilities 0 P200,000 P200,000
Owners’ equity P100,000 - 100,000
Debt/equity ratio 0:1 2:1

Making use of borrowed capital should be considered advisable only to the extent that it
will not endanger the financial stability of a company. Aside from the financing charges to
be met, the periodic maturity of the principal has to be provided for in cash budgets.
MANAGEMENT OF CASH RECEIVABLES, INVENTORY AND CURRENT LIABILITIES

Establishing good financial habits applies to managing cash, as well as other areas
of personal finance. Cash management - the routine, day-to-day administration of cash
ad near-cash resources, also known as liquid asset, by an individual or family. They are
considered liquid because they are either held in cash or can be readily converted into
cash with little or no loss in value.

In addition to cash, there are several other kinds of liquid assets, including checking
accounts, saving accounts, money market deposit accounts, money market, mutual
funds, and other short-term investment vehicles. Exhibit 3.1, briefly describes some of the
more popular types of liquid assets and the representative rates of return they earned in
Fall 2003. As a rule, near-term needs are met using cash on hand, and unplanned or
future needs are met using some type of savings or short-term investment vehicle.

Exhibit 4.1

Where to Stash the Cash

The wide variety of liquid assets available meets just about any savings or short-term
investment need. Rates vary considerably, so shop around for the best interest rate.

Type Representative Description

Rates of
Return (Fall
2003)
Cash 0% Pocket money; the coin and
currency in one’s possession.
Checking account 0-1% A substitute for cash. Offered by
commercial banks and other
financial institutions such as savings
and loans and credit unions
Savings account 1% Money is available at any time but
cannot be withdrawn by check.
Offered by banks and other financial
institutions.
Money market 1-2% Requires a fairly large (typically
deposit Account P1,000 or more) minimum deposit.
(MMDA) Offers check-writing privileges.
Money market 1-2% Savings vehicle that is actually a
mutual fund mutual fund (not offered by banks,
(MMMF) S&Ls, and other depository
institutions) Like an MMDA, it also
offers check writing privileges.
Treasury Bill (T-bill) 1% Short-term, highly marketable
security issued by the Bureau of
 Treasury (originally issued with
maturities of and 26 weeks);
smallest denomination is P1,000.
Savings bond (EE) 2-3% Issued by the Bureau of Treasury;
rate of interest is tied. Treasury
securities. Long a popular savings
vehicle (widely used with payroll
deduction plans) Matures in
approximately 5 years; sold in
denominations of P50 and more.

In personal financial planning, efficient cash management ensures adequate funds

for both household use and an effective savings program. The success of your financial
plans depends on your ability to establish and adhere to cash budgets.

An effective way to keep your spending in line is to make all household transactions
(even the allocation of fun money or weekly cash allowances) using a tightly controlled
checking account. In effect, you should write checks only at certain time of the week or
month and, more important, you should avoid carrying your checkbook (or debit card)
with you when you might be tempted to write checks (or make debits) for unplanned
purchases. If you are going shopping, establish a maximum spending limit beforehand -
an amount consistent with your cash budget. Such a system not only helps you avoid
frivolous, impulsive expenditures, but also documents how and where you spend your
money. Then, if your financial outcomes are not consistent with your plans, you can better
identify causes and initiate appropriate corrective actions.

Another aspect of cash management is establishing an ongoing savings program, an

important part of personal financial planning. Savings are not only a cushion against
financial emergencies, but a way to accumulate funds to meet future financial goals. You
may want to put money aside so you can go back to school in a few years to earn a
graduate degree, or buy a new home, or perhaps take a vacation. Savings will help you
meet these specific financial objectives.

Reference:
Flores, M. (2016). Business Finance For Senior High School. Unlimited Books Library
Services & Publishing Inc.