Test I.

Direction

CHAPTER 2: BASICS OF FINANCIAL MANAGEMENT

The study of financial management is integral to organizations in making financial

decisions. Business leaders and managers need to develop basic skills in financial
management. There is a need to identify and review the essential parts of financial
management to ensure the achievement of its goals.

1. Define management as an integral part of financial management.

2. Discuss financial management and its goals.
3. Identify the tools used by financial managers.
4. Discuss the resources used by organizations, its types, ownership including its
advantages and disadvantages.

Management – is defined as utilizing the scarce resources of the organization to

maximize attainment of the organization’s goals and objectives.
- The social process of working with and through others to achieve organizational
objectives in a changing environment. Krietner (1995).
- The process of designing and maintaining an environment in which individuals,
working together in groups, efficiently and effectively accomplish selected aims and
targeted goals.

Productivity is the output-input ratio (output/input) within a time period taking into
consideration quality.
Productivity = efficiency + effectiveness.
Efficiency is the quality of attaining desired objectives with the least amount of
resources.
Effectiveness is the attainment of goals on a continuing basis.

Productivity can be improved by:

1. increasing output with the same input;
2. decreasing input with the same output; and
3. increasing output with decreased input.
Input consists of labor, materials, and capital.
Management is concerned with utilizing the scarce resources of the organization to
maximize the attainment of the organization’s goals and objectives. It has four basic
components:
1. achievement of goals and objectives;
2. working with and through people;
3. maximization of limited resources by achieving productivity through efficiency and
effectiveness; and
4. coping with a changing environment.

Financial management, also called managerial finance, is concerned with

management of funds. It is the efficient and effective allocation, acquisition, and
utilization of funds. It aims to maximize:
1. wealth;
2. the value of the company; and
3. the value of stakeholders.

Financial Management, also referred to as managerial finance, corporate finance,

and business finance is a decision making process concerned with planning , acquiring
and utilizing funds in a manner that achieves the firm’s desired goals.
The goal of financial management is to maximize the current value per share of the
existing stock or ownership in a business firm.
Objective setting is thus, an important phase in the business enterprise since upon correct
objectives setting will the entire structure of the strategies, policies and plans of a
company rest. Firms have numerous goals but not every goal can be attained without
casing conflict in reaching other goals.

Financial management is concerned with the maintenance and creation of economic

value or wealth (Keown et al. 1998).
Director of finance, VP-Finance, or finance manager – the person in charge of the
finance function. He is responsible for the allocation of the financial resources of a
company, the acquisition of additional funds needed, and the utilization of these financial
resources to attain organizational objectives.
A goal sets direction and keep those concerned focused. It provides a reference to
measure performance and progress. It is the target toward which members of the
organization need to move forward to.
Goals of the financial manager include:
1. acquiring of funds with the least cost from the right sources as the right time;
2. effective cash management;
3. effective working capital management;
4. effective investment decisions;
5. proper asset selection; and
6. proper risk management.

Tools of Financial Managers:

1. financial policy-making – includes the tasks of selecting financial goals, developing

financial policies, and designing the finance organization to carry out the finance
function.
2. financial planning and budgeting – preparing plans to attain set goals, preparing
forecasts and budgets, and comparing actual performance with budgets to
determine variances and determine actions needed to correct such variances.

Forecasting is an integral part of the planning process. Budgeting is a sort of

forecasting.

3. financial analysis – the process of evaluating business performance, projects,

investment options, and other finance-related activities to determine feasibility and
profitability. It includes the analysis of the financial statement of a company to
determine financial stability, liquidity, and profitability.

The Financial Planning Process

1. Where are we now?

 This requires the analysis of the current financial statements of a company.
Looking into its financial statements to detect areas of strengths and weaknesses
as indicated by the measures of liquidity or short-term solvency, profitability and
stability.
2. How did we get here?
This requires an interpretation of historical data which may reveal the causes of
current financial stability or difficulty such as sufficiency or insufficiency of fund
inflows from operations.
3. Where do we want to go?
The different alternatives are evaluated and the best choice is made considering
the projected outcomes that requires financial projections such as estimates of
cash flows, revenue, costs and expenses and the financial ratios result.

Budgeting

Budgeting is the process of translating a plan in quantitative terms usually monetary

through a formal statement called the budget.

Master Budget

The consolidation of all the budgets of the different sub-units (departments, branches,
and sections) in an enterprise is called the master budget. It consists of the
following:
1. Operating budget or profit plan. This refers to the plan of operations wherein
details of revenues and expenses are shown and takes the form of budgeted income
statement.
2. Financial resources budgets – These show the effects of the profit plan on the
financial resources of the company and consist of the budgeted balance sheet and
cash budget.
3. Capital expenditures budget – This is in the form of a statement showing the
planned procurement and disposal of plant, property and equipment.

The Cash Budget

The cash budget shows the effects of management’s plans on cash inflows and
outflows. Thus, it may be prepared showing estimated cash receipts and
disbursements and the ending cash balance.
 Source: https://especiales.europasur.es/scar.php?how=balance-sheet-homework-help

Sources of Capital

1. Equity Capital – This refers to the financial resources provided by owners of the
business. It may be in the form of initial and additional investments plus earnings
retained in the business.
2. Borrowed capital – Capital acquired that gives rise to a liability is borrowed
capital.

Cost of borrowed capital – interest is paid on borrowed capital. 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.

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

Ex. ABC Corp. obtained a 20%, P200,000 one-year loan from DEF Financing Co.
Income tax rate is 35%. The cost of capital from the source is computed as follows:
 Interest of 20% on P200,000 P 40,000
Tax benefit (35% of P 40,000) 14,000
Interest expense net of tax benefit P 26,000
Percentage (P26,000/P200,000) 13%

Types of Business Organizations

A. as to nature or purpose
1. service – rendering service as catered in barber shops, spa and massage clinics,
dental/medical clinics, laundry shops, among others.
2. trading/ merchandising – buying and selling goods like sari-sari store, hardware
stores, construction supply stores, department stores, among others.
3. manufacturing – converting raw materials into finished products like in shoes and
bags manufacturing, furniture manufacturing, chicharon or native delicacies
manufacturing. They buy lumber to be converted into furniture, leather into bags
and shoes, among others.
4. banking and finance – deals with institutions involved in lending and borrowing.
These are banks, pawnshops, money lenders, insurance companies and pre-need
companies, credit card companies, among others.
5. mining/ extractive industries – extract natural resources like the gold mining
companies, gravel and sand quarrying, among others.
6. construction companies – engaged in road building, house building, construction
of different buildings like schools, hospitals, commercial apartments, among
others.
7. genetic industries – involved in the production, multiplication, and reproduction of
certain species of plants and animals like agriculture, fishing, animal husbandry,
poultry farming, plant nurseries, among others.

B. as to legal forms ownership

1. sole proprietorship – owned by only one person.
2. partnership – association of two or more partners who agreed to contribute
money, property, or industry to a common fund for the purpose of dividing the
profits among themselves.
3. corporation – an artificial being created by operation of law, having the right of
succession and the powers, attributes, and properties expressly authorized by law
or incident to its existence.
4. cooperative – organization established by members to provide themselves with
goods and services or to produce and dispose of the products of their labor.
Sole or Single Proprietorship
The sole proprietorship is a form of business entity that is owned and managed by a
single person. It is the most common form of business ownership.

Advantages
1. Ease and Cost of Formation – Among the three ownership forms, the sole or single
proprietorship is the easiest and least costly to organize. Only one person makes
decisions and could do whatever he wants with the business. Business
requirements are easy to process and are not as extensive as those of the other
forms of ownership.
2. Secrecy - The sole proprietorship keeps his business intentions secret. The
competitors can only guess of his business activities.
3. Distribution and use of profits – The owner of the business is the sole beneficiary of
the profit earned. He can decide on whatever he wants to do with the income
earned.
4. Control of the business – The owner has the power to control his own business
especially under critical competitive situations.
5. Government Regulation – The owner is spared from various government rules and
required only to submit fewer reports.
6. Taxation – the owner is taxed accordingly.
7. Closing the business- This ownership can be dissolved by the owners at their own
will and does not need to seek the approval of others.

Disadvantages
1. Owner’s Lack of Ability and Experience – managing a business requires management
skills. An owner who lacks this skills will find it hard to succeed in the business.
2. Difficulty in Attracting Good Employees – This form of ownership is not known for
surviving long periods. The existence is co-terminus with the life of its owner.
Good employees would prefer a more stable enterprise, which is more likely a
corporation.
3. Difficulty of Raising Capital - Raising capital depends on the financial resources of
the owner especially if the business plans on expanding the business. Even if he can
obtain credit, the amount will depend on his capacity to pay.
4. Limited Life of the Firm – the existence of this form of business depends on the
physical well-being of the owner. Death of the owner will mean liquidation of the
firm.
5. Unlimited liability of the Proprietor – any liability incurred by the owner extends to
his personal assets. Unlimited liability is the greatest disadvantage of the sole
 proprietorship.

Partnership
A partnership is a form of business ownership owned and managed by two or
more persons. The owners are usually called partners. All the partners may contribute
money, property, or industry, and their contributions become a common fund of the
partnership.

Advantages
1. Ease of formation - like sole proprietorship, partnership are easy to form. A
written agreement called the Contract of Partnership is drawn to formalize what has
been agreed upon.
2. Pooling of Knowledge and Skills – Partners’ combined knowledge and skills will be a
distinct advantage of the business.
3. More funds available - Partners combined their resources that leads to a substantial
capital and financial capabilities for the partnership.
4. Ability to Attract and Retain Employees - Partnership businesses can extend their
partnership agreement to valuable employees. This could minimize the possibility of
competition between employees.
5. Tax Advantage – any profits earned by the partnership is part of their individual
income and are taxed individually.

Disadvantages
1. Unlimited Liability – The liability of one or two partners is part of the burden of the
remaining partners.
2. Limited Life – When one of the partners die or withdraw his or her ownership from
the business, the partnership is terminated. The life of the partnership will depend
on the health and willingness of all the partners.
3. Potential Conflict Between Partners – Conflicts and disagreements between partners
may affect their performance. Operations will be affected that will lead to
bankruptcy and solvency.
4. Difficulty in Dissolving the Business – In partnership dissolution, distribution of
assets and liabilities are to be shared by the partners. Assets of the business may
be fixed or immovable and it takes time to convert them into cash making it difficult
to dissolve.

Types of Partnership
1. General Partnership
2. Limited Partnership
Corporation
A Corporation is a legal entity formed and operated by law, having the rights of
succession, the right to acquire assets and can sue or be sued.

Advantages
1. Limited Liability – The liability of each stockholders is limited to the amount of
shares invested in the corporation. Beyond the value, he has no more liability.
2. Ease of Expansion – The corporation is granted an authority to sell shares of stocks
to interested investors. It is easy for corporations to accumulate large amount of
capital making their business easier to consider expansion.
3. Ease of transferring ownership –it is easy to transfer ownership in a corporation
since the shares of stocks can be transferred or sold to other investors.
4. Relatively Long Life – Ownership is transferrable and death or withdrawal of any
stockholders does not terminate the corporation. The corporation may continue to
exist for up to 50 years and renewable.
5. Greater Ability to Hire Specialized Management – The possibility for expansion of
operations of the corporation makes it possible to divide the jobs into specialized
positions. There is a need to hire specialized people to do the jobs. With specialized
management, the corporation will continue grow and develop vigorously.

Disadvantages
1. More expensive and complicated to organize – The corporation is subject to many
governmental requirements. It takes time to complete its requirements and needs a
lot of money and effort.
2. Double Taxation – Profits made by the corporation are taxed and part of
stockholders’ dividend is also being taxed as their individual income.
3. Government restrictions and requirements – Corporations has many restrictions and
is required to submit various reports on a periodic basis.

Classes of Shares of Stocks

Common Stocks – represents the basic issue of shares and has all the basic rights of a
share. If a corporation issues only one class of capital stock, it is classified as
common stock.

Preferred Stock – is a class of stock with preferences over common shares, including
distribution of dividends and corporate assets upon dissolution of the corporation.
Dividends – This is the amount of money or items of value received by stockholders
from his investment in a corporation. All assets and earnings of a corporation are
owned by the company and not by its stockholders which can be transferred upon
declaration by the board of directors for dividends distribution.