Chapter 1

Introduction
Finance is the study of how individual s or businesses evaluate investment opportunities, business proposals, and
business projects, and raise capital to fund them.
Financial Management is the efficient and effective management of funds.

The Financial Environment

Understanding business finance requires an appreciation of the financial environment. The financial environment is
characterized by its three interacting areas. These areas are (1) financial institutions and markets; (2) investments;
and (3) financial management.

The first area involves financial institutions and financial markets. Financial institutions are organizations or
intermediaries that help the financial system operate efficiently and transfer funds from depositors and investors to
individuals, businesses, and governments that seek to spend or invest the funds in tangible assets. These organizations
provide financial services by dealing with the management of money. They include banks, insurance companies, and
lending institutions. To facilitate operation and transfer of financial resources, financial markets play an important role.
Financial market is a broad term that describes any market place where trading of securities such as shares, bonds
and currencies occurs. Financial markets take the form of either a physical or electronic medium.

In the Philippines, we have the Philippine Stock Exchange (PSE). The second area is investments. This area focuses
on the decisions made by businesses and individuals as they choose securities for their investment portfolios. This
involves the sale or marketing of securities, the analysis of securities, and the management of investment risks through
portfolio: diversification.

The third area is financial management. It involves financial planning, asset management, and decisions to increase
the value of the stakeholders. This aren is often attributed to business finance because it deals with decisions
concerning cash flows, including both inflows and outflows, Decisions can range from the strategic (like business
expansions-choosing what types of securities to issue to finance such expansions) to operational (like how much cash
or inventory the business should carry). This role primarily rests on the financial manager of the business.

Various Financial Institutions or Intermediaries

Financial institutions include banks, insurance companies, and lending institutions, among others.
Banks - supervised and regulated by the Bangko Sentral ng Pilipinas (BSP), an establishment for the deposit, custody,
and issue of money, for making loans and for making the exchange of funds easier.
Universal and commercial banks - represent the largest single group, resource-wise, of financial institutions in the
Philippines. They accept deposits and make loans to individuals and businesses. In addition, they are authorized to
engage in underwriting and other functions of investment houses, and to invest in equities of non-allied undertakings

Thrift banks - represent noncommercial banks composed of savings and mortgage banks, private development banks,
stock savings and kaa associations and microfinance thrift banks. They accumulate saving of depositors and invest
them. They also provide short-term working capital and medium- and long-term, financing to businesses engaged in
agriculture, services, industry and housing, and diversified financial and allied services, and to their chosen markets
and constituencies, especially micro, small and medium enterprises and individuals.
Savings banks - accept the savings of individuals and lend pooled saving to individuals primarily in the form of
mortgage loans.
Rural and cooperative banks - represent the more popular type of banks in the rural communities. Their role is to
promote and expand the rural economy in an orderly and effective manner by providing the people in the rural
communities with basic financial services. Rural banks are privately owned and managed while cooperative banks are
organized and owned by cooperatives or federations of cooperatives.
Insurance companies - supervised and regulated by the Insurance Commission, these are companies that offer
insurance policies to the public, either by selling directly to an individual or through another source. Comprised of
multiple insurance agents, they can specialize in a particular type or types of insurance such as life insurance, non-life
insurance, health insurance, or auto insurance, among others.
Lending institutions - similar to non-banks with quasi-banking functions, they make loans available to individuals and
businesses.
The Role of the Financial Institution
The flow of money begins with the individual who deposits in the bank, a financial institution. This depositor opens up
a bank account and earns an interest from this account. In turn, these funds are lent by the banks to businesses, the
borrowers, who either start-up a new project, a new line of product, or merely expand operations. As the business
earns profits, the borrower of the funds is able to pay interest on the loan, and the depositor receives an interest on his
bank account.
The role of the financial institution is always important in any growing economy. In Glen Arnold's inspiring book Financial
Markets, Financial Times, Guides, he explains that the major financial markets and economies in the United Kingdom
and the United States would not have grown without the significant role those financial institutions have played.
The main role of the financial institution is to act as financial intermediary. Acting as financial intermediary means to
be in the middle, to be the go- between, or link between the depositors who have the money and the borrowers who
need the money.
The offer to use the terminologies "sustainable" and "good returns over time" is deliberate to emphasize that most
funds especially public funds look for investment opportunities that will sustain their requirements for about five years
or more, in other words long-term, and this is to differentiate some investor requirements of quick returns.
Hence, financial management is the handling of all financial matters, including analyzing financial statements,
evaluating investment opportunities which happens before one actually starts investing, and raising capital or funds
from different sources.

The Key Individual Roles

The Creditor Who Has the Funds
The Creditor is the person who has the money and deposits it in a savings account with a bank that pools this together
with the savings from other depositors.

The Debtor Who Needs the Funds

The Debtor is the party at the other end. He is the small business owner. He is the one who needs the funds and
borrows the funds through a bank. He needs the funds to start a project or a business venture, or expand his ongoing
business. He knows where the funds can be placed or invested in so that the funds will grow. He evaluates his options
such as:

• a start-up (new business) venture;

• an expansion, Le, a purchase of a new equipment;
• equity in an ongoing business concern; and
• investing in financial instruments (such as money market placements, treasury notes, corporate notes,
corporate bonds, government bonds, local stocks, and foreign stocks).

Financial Instruments and Financial Markets

Financial institutions include banks and nonbanks. These are your commercial banks, universal banks, investment
banks, investment companies, finance companies, life and nonlife insurance companies, mutual fund companies, and
private equity firms. By understanding their role, you will appreciate why they are very important in the growth of any
economy. They move funds that move businesses, which in turn move people and bring their livelihoods forward.
Financial instruments are the tools that help a business' daily operations, and eventually make it grow. These tools
help the finance manager handle his cash, his short-term operating requirements, and long-term business
requirements.
Money market instruments are an inexpensive way for government and financial institutions to raise funds. These
funds are usually available for short periods of time; therefore, their rates are generally lower than funds which are
available for use over longer periods of time,
Compared to savings deposits, money market instruments earn higher interest. Investors who can be individuals or
business owners’ avail of these instruments because of their liquidity. They are available most of the time when needed
and can be accessed when the business needs them. They are safe as these are quality investments for short periods
but do not provide very high returns compared to long-term investments

Financial Instruments Basic Characteristics

Monet Market Debt:

Treasury Bills • Issued by the treasury/government

• Matures within one year
• Is generally default-free as government will exert all
effort to pay

Commercial Papers • Issued by financially-sound businesses to fund

investments in inventories and receivables
• Maturity is about nine months
• Generally low default risk as businesses has good
credit standing.

Money Market Funds • Issued by banks or mutual fund companies

• No Specific maturity dates
• The degree of default risk is low
• These funds are usually invested in money market
instruments, treasuries, and commercial papers.

Consumer credit, and debit cards • Issued by banks, credit unions, finance companies
• Maturity date varies
• Default risk varies

Long-Term Debt:

Treasury Notes and Bonds • Issued by the government

• Notes matures within two, five, or ten years
• Bonds mature longer (10 years or more
 • No default risk as governments exerts all efforts to pay
• The price of bonds usually falls, becoming less attractive as
interest rates in the markets rise

Federal agency debt • This is a United States type of long-term debt and not applicable
in the Philippine setting.
• Issued by federal agencies and is similar to treasuries.
• Has long-term maturity (i.e., up to 30 years)
• Has low default risk

Municipal bonds, Local Government • Issued by local governments

Bonds • Matures Longer (i.e., up to thirty years)
• Riskier than government securities

Corporate Bonds • Issued by corporations

• Matures in the forty years
• Riskier than government securities and rely on the financial
soundness of the company

Stocks:

Preferred Stock • Issued by corporations in exchange for units of ownership

• Has no maturity date
• Pays dividends when declared
• More risky than corporate bonds
• Has no voting rights
• Has preference over common stocks in asset liquidation, hence
the term “preferred”

Common Stock • Units of ownership in a public corporation

• Pays dividends when declared
• Owners are entitled to vote on the selection of directors and other
important matters.
• In the event of a corporate liquidation , claims of preferred
stockholders take precedence over common stockholders
• For the most part, common stockholders enjoy potential profits
from the capital appreciation of their stocks.