Chapter 8: Corporate Stocks

The capital requirements of the firm may be classified into three: (1) short-term; (2) intermediate-term;
and (3) long-term. Chapter 7 dealt with the sources of short-term capital. Intermediate and long term
sources of financing will be presented in separate chapters.

The long-term capital requirements of the firm involve the accumulation of values or fixed assets. At the
organizational stage, the firm will require funds for the acquisition of plant and equipment, furniture
and fixtures. After a certain period, management may decide to expand its activities, acquire an existing
firm, refinance its own operations, or organize new ventures. Long term capitalization will be required in
each of the foregoing cases.

There are two primary sources of long-term financing: the sale of stocks and bonds. In this particular
chapter, corporate stocks as a source of long-term capital shall be discussed.

STOCK FINANCING

When shares of stock are sold to raise funds for the long-term financing requirements of the firm, this
activity is referred to as stock financing. The object of stock financing is to increase equity capital. Large
and small firms achieve this by selling shares of stock. Public utility firms in the Philippines, for instance,
finance their expansion through stock financing. The sale of stock to subscribers of the Philippine Long
Distance Company is an example of such activity.

As banks adapt a discriminating attitude towards granting long-term loans to small and medium-scale
businesses, stock financing becomes a useful alternative.

THE ADVANTAGE OF STOCK FINANCING

Stock financing as an option for long-term financing has a Raising long-term capital through stock
financing does not burden distinct advantage over the other option, which is bond financing the
company with the pressure of redeeming the stocks at a given date. This is because stocks, unlike bonds
have no maturity periods. As such funds generated through stock financing may be used continually
without the burden of renewals which are inherent to the other sources of long-term financing.
Furthermore, common stocks, unlike bonds are not interest-bearing. Also, the issuance of stocks does
not require collaterals

CAPITAL STOCK, DIVIDENDS, AND RETAINED EARNINGS

The interest of the owners of a corporation is called capital stock It is divided into shares, with each
share representing a portion of the total ownership interest. A portion of the authorized stock which has
been issued and sold is called issued stock. Those which are not yet issued are called unissued stock.
The capital stock appearing in the firm's balance sheet is nominal unlike the figure indicated in its
charter.

The net income of a corporation may be distributed to the stockholders in the form of dividends. There
are times, however, when the profits are not declared as dividends. Instead, it is retained in the
company's coffers for use in some of its capital financing requirements. This is reported as retained
earnings in the company's balance sheet.

The retained earnings account increases the actual and the market value of the company's shares of
stock. Exhibit 4 shows a typical equity section of a corporation's balance sheet.

CLASSES OF CORPORATE STOCKS

Corporate stocks may be classified into two major classes: (1) common stock; and (2) preferred stock.

Common Stock

-Common stock is that class of stock issued by all corporations and which represents the real equity
capital. It has a residual claim (after debts have been paid) to earnings and assets and which carries the
risk of business success or failure.

Varieties of Common Stock. Common stock has been issued various forms and for various reasons.
Variations in common stock issues consist of the following:

1. classified common stock

2. deferred stock

3. voting trust certificate

4. guaranteed stock

5. debenture stock.

Exhibit 4

A TYPICAL BALANCE SHEET

ISABELO MUSNGI CORPORATION

Balance Sheet

As of December 31, 2006

ASSETS:

Current assets -P 14,045,000

Investments in securities of other companies -1,797,000

Plant and equipment -7,513,000

Other assets -1,420,000

Total Assets= P 24,776,000

EQUITIES:

Current liabilities- P 6,950,000

Long-term debt- 3,933,000

Total Liabilities= P 10,883,000

Preferred stock- P 305,000

Common stock actually outstanding including capital surplus- 5,011,000

Retained earnings- 8,577,000

Total Stockholders' Equity- P13,893,000

Total Equities= P 24,776,000

Classified Common Stock.

Common stock may be classified to suit various requirements of the issuing firm and investors. Class A
stock, for instance, may give the stockholder preference over Class B stockholders in terms of dividend
payments and asset claims in case of liquidation. In some instances, Class A stock has the right to
convert to Class B common stock at an attractive price if the corporation proves to be successful in its
expansion. These preferences, however, impose certain restrictions
Chapter 9: Corporate Bonds

Bonds constitute the alternative source of long-term financing The other means is the stock, which has
been discussed in the previous chapter Bonds do not represent equity capital, but they are long-term
liabilities of the company

DEFINITION OF BOND

A bond is defined as a long-term debt of a firm or the government set forth in writing and made under
seal

KINDS OF BOND

There are general kinds of bonds. These are the following

1. government bonds; and

2 corporate bonds.

Government bonds are those issued by the government to finance its activities. Corporate bonds are
those issued by private corporations to finance their long-term funding requirements. In this chapter,
corporate bonds as a source of long-term financing shall be presented.

Like a long-term loan, a bond is a long-term contract under which a borrower agrees to make payments
of interest and principal. on specific dates, to the holder of the bond. Unlike long-term loan a bond issue
is generally advertised, offered to the public, and actually sold to many different investors.

BONDS AS DISTINGUISHED FROM STOCKS

As distinguished from stocks, bonds possess the following characteristics:

1. A bond is a debt instrument, while stock is an instrument of ownership:

2. Bondholders have priority over stockholders when payments are made by the company;

3. Interest payments due to bonds are fixed, while dividends. to stockholders are contingent upon
earnings and must be declared by the board of directors;
4 Bonds have specific maturity date, at which time, repayment of the principal is due. In contrast, stocks
are instruments of permanent capital financing and does not have maturity dates; and

5. Bondholders have no vote and no influence on the management of the firm, except when the
provisions of the bond and the indenture agreement are not met.

ALTERNATIVE WAYS OF BOND ISSUANCE

Corporate bonds are generally sold by medium-and-large-sized companies to finance plant and
equipment. Small firms do not usually use this financing method.

Bonds are issued through any of the following ways:

1. public offering; and

2.private placement.

Public offering involves selling of corporate bonds to the general public though investment bankers. The
investment banker provides assistance in the issuance of bonds by:

1. helping the firm determine the size of the issue and the type of bonds to be issued;

2. establishing the selling price; and

3. selling the issue.

Private placement is a sale of bonds directly to an institution and is a private agreement between the
issuing company and the financial institution without public examination.

Private placement offers the following advantages:

1. the issue can be tailor-made to fit the needs of the issuing firm, as well as the investing firm;

2. the issue does not have to be registered; and

3.there are no underwriting fees paid by the issuing firm.

CLASSES OF BONDS

By major contractual provisions, bonds may be classified into three general types: (1) by type of
security; (2) by manner of participation in earnings; and (3) by method of retirement or repayment.
Classification of Bonds as to Type of Security

Bonds may be classified according to the type of security offered by the issuing firm. These consist of the
following:

1. Earnings and general unpledged assets of issuing company (debentures);

2. Earnings of issuing company plus pledge of specific property (mortgage bonds). This is further
classified as follows:

a. Real estate mortgages (senior and junior liens)

i. Closed-end issues.

ii. Open-end issues

b. Chattel mortgages

3. All or some of original security plus general credit of another company which may be

a. Assumed bonds

b. Guaranteed bonds

4. Combined earnings of allied companies plus collateral protection in some cases (joint bonds).

Debentures.

Debenture bonds are general credit bonds not secured by specific property. The earning power of the
issuing corporation provides the protection to the debenture bondholder. The claim of debenture
bondholders is superior to any stockholder regarding unpledged property of the issuing corporation.

Mortgage Bonds. Mortgage bonds are those which are secured by a lien on specifically named property
such as land, buildings, equipment, and other fixed assets. Mortgage bondholders have a prior claim to
the assets specifically pledged as security.

The specific property pledged are of two general types:

1. real estate - which consists of land and property attached to the land;

2. chattels-which consist of personal and movable property.

Real estate mortgages may also be classified according to priority of claims:

1: Senior liens. They are those having prior claim to fixed assets pledged as security. Bonds with senior
liens are also sometimes called first mortgage bonds.
2. Junior liens. They are bonds having subsequent liens to fixed assets pledged as security. They have a
subordinated priority claim to the senior

Chapter 11: The Capital Market

Basic courses in economics are replete with discussions on savings and investment. The savers are said
to be those consisting of individuals, families, or households who do not intend to exercise entirely their
ability to spend. In short their motivation is to save Investors on the other hand consist of individuals or
firms wanting to purchase asset or capital goods with the object of obtaining benefits from such
purchase. The amount of invested funds may consist entirely of the investor's own money or it may be
supplemented by outside sources. The foregoing brings out two significant areas of concern (1) the
available funds provided by the savers; and (2) the capital funding requirements of individuals and firms

The financial system works by providing intermediation between the suppliers of credit, ie, the savers,
and the users of credit. individuals and business firms. The intermediaries consist of financial
institutions which, in turn, are tapped by the borrowers 822 for their financing requirements. These
institutions are sometimes referred to as financial markets.

Financial markets may be classified into two: (1) the capital market; and (2) the money market. This
chapter will deal with the 18 capital market.

CAPITAL MARKET DEFINED

The capital market is that portion of the financial market which deals with longer term loanable funds.
The money market, in contrast, deals with short-term funds Loans obtained from the capital market are
used by industry and commerce mainly for fixed investment. The capital market consists of all
institutions that canalize the supply and demand for long-term capital and claims on capital, which in
effect, comprises the entire structure of the Philippine financial system

COMPONENTS OF THE CAPITAL MARKET The capital market is composed of three parts:

1 the bond market

2 the mortgage market, and

3 the stock market

The market for debt instruments of any kind is called the bend market. Trading in the bond market is
primarily done over-the counter. Most bonds are owned by and traded among the large financial
institutions like lite sneurance companies, mutual funds and pension funds
The mortgage market is that portion of the capital market which deals with loans on residential
commercial, and industrial real estate, and on farmland

The stock market is that portion of the capital market where the common and preferred stocks issued
by corporations are traded. It has two components

1. the organized exchanges and

2. the less formal over-the-counter markets

There are many organized exchanges throughout the world like the New York and the London stod
exchanges. In the Philippines stocks are openly traded in the Philippine Stock Exchange. The companies
whose stocks are traded in the Philippine Stock Exchange are classified as follows:

1. banks

2. financial service

3. communication

4 power and energy

5. transportation services

6. construction and other related products

7. holding firms

8. food, beverages, and tobacco

9. manufacturing, distribution, and trading

10. hotel, recreation, and other service

11. bonds, preferred and warrants

THE COST OF CAPITAL

Additional capital is desirable only if additional benefits will be derived from the exercise. The more
desirable it becomes when the percent increase of benefits is higher than the percent increase in capital
investments. For example, a company made a 30% increase in its investments and as a result, a 100%
increase in net profits was realized. Of course, this investment is desirable..

As new capital funds are made available by various sources, decisions on which of the different sources
must be tapped should be based on the cost of such procurement of new capital and the additional
income to be derived from its use. The net earnings that may be derived from the different alternative
sources of capital must be calculated. A comparison of the cost of the different kinds of capital funds
must be made before deciding on the best combination that would maximize profits for the firm, or
attain the goals spelled out in Chapter Five For the purpose of illustration, a simple analysis of such
calculation will appear as follows:

The computation shows that the best alternative source of financing available for the tumis Alternative
Number 3. The choice means that a twenty million pesos net profit will be derived if the one million
peso capital requirement is funded from the sale of preferred stocks. The least profits will be derived if
the capital requirement is funded by short-term debts. The computation also shows that if the
requirement is financed jointly with the use of the three options, short-term debt, long-term debt, and
preferred stock profits will be moderate at 14 million pesos

BASIC TERMS DEFINED AND DISCUSSED

At this point, the terms corporate securities, primary market, and secondary market, need to be defined
and discussed.

Corporate Securities

So far, the term corporate securities has not been mentioned. As it will be used in discussions in the
succeeding pages, it is important that the meaning of this term be clarified.

Securities refer to income yielding paper traded on the exchange or secondary markets. A very essential
characteristic of a security is its saleability.

Types of Security.

There are three main types of security. These are the following:

1. fixed interest-consisting of debentures, preferred stocks, and bonds, including all government
securities;

2. variable interest - consisting of common stocks and bonds, as well as preferred stocks with
participating feature; and

3. others-like bills of exchange and assurance policies.

What Constitutes Securities.

The following are considered securities:

1. bonds;

2. debentures;

3. notes:

4. evidences of indebtedness:
5. shares in a company:

6. pre-organization certificates of subscription:

7. investment contracts

8. certificates of interest or participation in a proht sharing agreement

9. collateral trust certificates

10 voting truest certificates

11 equipement trust certificates:

12 certificates of deposit for a security

13 certificate of assignment;

14. repurchase agreements

15 proprietary or non-proprietary membership certificates

16 commodity fatures contract

17 transferable stock options:

18. pre-ooed plans

19 pension plans

20. life plans

21 joint venture contracts and

22 other similar contracts and investments

Primary Market

When securities are issued and offered by the corporation for the first time to the public, buyers of such
issues are referred to as primary market. When the primary market buys securities, it actually provides
long-termin capital to corporations

Secondary Market

This term refers to the market dealing with the resale and purchase of securities or other titles to
property or commodities Examples are the secondary mortgage markets, where holders of mortgages
who need funds can dispose of their holdings before maturity. Another is the secondary stock market
involved in private placings and dealings among brokers, merchant banks, and other persons and
institutions.

The secondary market actually provides liquidity to investments made in the primary market. This is so
because when a buyer of securities in the primary market wants to convert his securities into cash
before maturity, the secondary market provides him with means for easy conversion.
SECURITIES OFFERING IN THE CAPITAL MARKET Firms may obtain long-term capital tunds through
security offerings in the capital market. As shown in Figure 15, the source of capital funds may be (1)
Institutional, or (2) non-institutional The institutional sources consist of banking and non-bank financial
institutions. The non-institutional sources on the other hand, consist of individual investors.

As shown in Figure 16, securities may also be disposed of in two ways: (1) by public offering; or (2) by
private placement Public offerings of securities may be directed to the general public, or to special
publics. Special publics consist of holders of securities of the issuing corporation, and special groups like
offerings, employees. and customers of the issaing corporation.

The Marketing of Securities

Corporate securities are distributed in two methods: (1) by primary distribution; and (2) by secondary
distribution

When the firm's securities are sold for the first time to the public, the activity is referred to as primary
distribution Primary distribution may be achieved through any of the following

1. the investment bankers:

2 private placement; and

3. individual investors.

When the first buyers of securities resell their interests to other parties, the activity is referred to as
secondary distribution. This may be achieved through the following:

1. stock exchanges; and

2. over-the-counter trading.

The Investment Banker. The investment banker is any person engaged in the business of underwriting
securities issued by other persons or firms. The term underwriting refers to the act or process of
guaranteeing the distribution and sale of securities of any kind issued by another corporation.

The investment banker is expected to perform the following functions:

1. to investigate the corporation's financial condition and needs;

2. to advise the corporation considering new issues of securities;

3. to originate new issues;

4. to arrange for syndicate distribution;

5. to underwrite securities and

6. to market securities
Investment bankers are sometimes referred to as investment houses

Private Placement. This term refers to the selling of securities by private negotiation directly to
insurance companies, commercial banks, pension funds, large-scale corporate investors, and wealthy
individual investors.

Private placement is contrasted with public offering or the offering of securities to the general public

Individual Investors. Individuals who either have excess funds, or willing to forego or postpone a part of
his ability to spend constitute a portion of the capital market. These individuals have the option of
depositing their money in banks, or they may look for sultable investments with higher rates of return.
To the individual, investments in securities become more attractive when interests paid on bank
deposits are low. The decision to invest in securities, however, will only be tempered by the risks
involved in such specific undertaking

Stock Exchange and Over-the-Counter Trading. The secondary marketing of securities is done through
the stock exchange or over-the-counter. These two alternative means will be discussed in the next
chapter.

UNDERWRITING AND SELLING THE FIRM'S SECURITIES

The underwriting of securities may be done using any of the following methods:

1. negotiated underwriting:

2 competitive underwriting:

3. commission sales;

4. direct sales; and

5. firm commitment basis.

Negotiated Underwriting

When the issuing firm and the investment banker meet and agree on the terms and conditions of the
underwriting, this method is referred to as negotiated underwriting.

Several steps are required in the use of this method. These are the following:

1. The firm decides that additional funds are needed and a suitable investment banker is identified.

2. A pre-underwriting conference is made between the firm and the investment banker. The following
items are discussed:

a. The appropriate amount of funds to be raised

b. The receptiveness of the capital market to different types of long-term securities

 c. The appropriate timing of such an issue and

d. The terms of the underwriting agreement between the investment banker and the firm

An underwriting syndicate is formed by the one who initiates the underwriting. The syndicate is a
temporary association of several investment bankers, with the number of participants varying from one,
when the initiating underwriter handles the whole issue, to a few dozens if the amount to be raised is
large. The initiating underwriter often becomes the manager of the syndicate and forms an agreement
with the other underwriters in the syndicate which defines the responsibilities, liabilities, and fees of
each and specifies the proportional amount of the issue each must purchase.

Competitive Underwriting

The competitive underwriting is similar to the negotiated underwriting except that the underwriting
group bids against other underwriting groups for the initial purchase of the securities at a public auction.

Commission-Best Efforts Basis

When the investment banker acts as a selling agent for the issuer and not as an underwriter, he is paid a
commission. The investment banker agrees to try his "best efforts" to sell the security. No guarantee is
made on the successful sale of the entire amount. Whatever is left over is returned to the issuing
corporation.

Direct Sale

There are instances when the issuer sells directly to the public, bypassing the underwriter entirely.

Firm Commitment Basis

The firm commitment basis is an underwriting agreement wherein the investment house agrees to
purchase the issue from the issuing corporation.

Working Capital
To obtain revenues, the firm strives to provide customers ducts or services. To achieve this,
various inputs are required in need of adequate funding. What is needed is a portion of the capital
which will take care of financing the day-to-day activities of the firm. This funding requirement
is covered by the firm’s working capital.
MEANING AND COMPOSITION OF WORKING CAPITAL
Working capital refers to that part of the capital of the company which is continually circulating.
It is circulating in the sense that the initial cash funds of the firm are converted into inventories,
which in turn are converted into cash or accounts receivable and ultimately into cash again.
Working capital may be described in two ways: (1) gross working capital, which is the total
amount of the firm's current assets; and
(2) working capital, which is the total amount of current assets minus current liabilities.
The gross working capital of the firm is usually composed of the following:
1. cash in the firm's safe;
2. checks to be cashed;
3. balances in the bank accounts;
4. marketable securities (not including stocks in subsidiaries);
5. notes and accounts receivable;
6. supplies;
7. inventories;
8. prepaid expenses; and
9. deferred items.

THE NEED FOR WORNING CAPITAL

Working capital is required for the following purposes:
1. Replenishment of Inventory. A sufficient stock of inventory is required to support the
sales target of the firm. This requirement, however, will depend on the availability of
resources. An unserved portion of demand may mean lost revenues for the firm.
2. Provision for Operating Expenses. To maintain the operations of the firm on a day-to-
day basis, a working capital is required. This will be needed to take care of salaries and
wages, advertising, taxes and licenses, insurance premium, and interest payments.
3. Support for Credit Sales. At times conditions require that credit sales be extended to the
firm’s clients. This will need sufficient working capital to enable the firm to maintain its
operations until receivables are converted into cash.
4. Provision of a Safety Margin. The firm should have sufficient amount of capital to
provide for unexpected expenditures, delays in the expected inflow of cash, and possible
decline in revenue.
Cash Requirements
The firm needs cash to pay for expenditures that arise from time to time. Even if the anticipated
cash receipts are equal to the anticipated cash expenditures. It is still necessary to maintain a
sufficient cash fund for the firm to meet its cash commitments. This is needed because of the
difficulty in synchronizing cash receipts with cash disbursements. It is therefore, required that a
positive cash balance be maintained so that the firm's obligations are settled as they become due
The amount of cash needed depends upon the following:
1. the amount of the firm's purchases and cash sales:
2. the time period for which the firm receives and grants credit
3. the time period from the dates of purchase of raw materials and payment of wages to the
dates of cash receipts from sales
4. the amount of cash to be used for investment in inventories: and
5. the amount of cash needed for other purposes such as cash dividends
Accounts Receivable Requirements
Since liquidity is a primary concern of sound business tina firms prefer cash sales over credit
sales. Many companies, however, cannot avoid the extension of credit to customers for various
reasons Credit is used to sustain and to promote production distribution and consumption of
goods and services.
The unpaid portion of credit sales is represented by accounts receivable in the firm's records. The
collection of accounts receivable from customers contribute to cash inflow requirements of the
firm.
Credit terms vary according to the degree of competition within individual industries, the
availability of bank credit, and pressures for increased sales in periods of increasing plant
capacities.
Inventory Requirements
The production of large stocks of inventory generate savings as a result of lower production cost.
It will also provide the firm with large quantity of stocks to meet increasing or unusually large
orders from customers. The maintenance of large stocks of inventory, however, may
unnecessarily tie up funds which could have been made available for other uses. Outside
financing may even be required. In addition, storage and warehousing costs may also increase.
The ideal set-up is for the firm to make sales as soon as finished products come out of the
production line, or to acquire raw materials and supplies as soon as they are needed. Since these
are not possible, economists have devised a method of knowing the inventory level that will
optimize results considering both above-mentioned requirements.
MANAGEMENT OF WORKING CAPITAL
Working capital must always be able to cover fund requirements of the company as they are
needed. There are times when unusual pressures on working capital makes the job of the finance
manager very difficult. To overcome this, a system be adapted considering the following
objectives:
1. Working capital must be adequate to cover financial requirements. It must be allocated
am needs in sufficient amounts. The quantity of stocks to be carried and the maximum
allowable of receivables must be decided in advance.
 2. The working capital structure must be liquid meet current obligations as they fall due.
Salaries and wages must be paid on time. Raw materials and must be acquired on days
they are needed.
3. Working capital must be conserved through proper allocation and economical use. It
must be protected losses arising out of natural calamities, malversation, or pilferage.
4. Working capital must be used in the attainment of profit objectives of the firm.
Measures to contribute increased profits through avoidance of loss must be instituted.
LIQUIDITY MANAGEMENT
Liquidity refers to the ability of the firm to pay its bills on time or otherwise meet its current
obligations. Activities geared towards is called liquidity achieving the liquidity objectives of the
firm management.
The objective of management is to acquire sufficient amounts of funds to cover the cash
requirements of the firm. The cash inflows of the firm come from various sources which are
briefly described as follows:
1. Cash Sales. The percentages of cash derived from sales vary from company to company and
from industry to industry.
2. Collection of Accounts Receivables. The credit policies and the pattern of company sales
determine the frequency and volume of collections from receivables.
3. Loans. Loans from banks and other creditors may be availed of by management mostly on its
own initiative. The timing and amount of cash receipts derived from depend largely on the
borrowing firm.
4. Sale of Assets. Assets are sometimes sold by the company for various reasons. Obsolescence
is one of those.
5. Ownership Contribution. Additional contributions owners are sometimes tapped to improve
the liquidity posture of the firm.
6. Advances from Customers. Manufacturers, at times, require cash advances from customers
as soon as an o is made and before production is started. This is not unusual especially if the
objects of sale are capital like airplanes and ships. The number of years required the
manufacturing process justifies whatever cash advances are required from customers.
Cash Management
Idle cash earns nothing and even if it is kept in a bank, the interest it earns is minimal. If
sufficient amounts of profits must be attained, cash should be invested. Sufficient cash must be
maintained, however, to cover the firm's cash expenditures. The activity involved in achieving
these two opposite goals is called cash management.
To effectively manage cash, five major approaches are suggested. These are as follows:
1. Exploit techniques of money mobilization to reduce operating requirements for cash;
2. Expend major efforts to increase the precision and reliability of cash flow forecasting;
3. Use maximum efforts to define and quantify the liquidity reserve needs of the firm;
4. Develop explicit alternative sources of liquidity; and
5. Search aggressively for more productive uses of surplus money assets.
Money Mobilization.
Some companies maintain branches and agencies in distant places. Those that serve customers
directly may find that they are also serving customers from far-flung areas. These two conditions
are characterized by remittances which take several
days before they are converted into usable cash balances. Checks payments, for instance, are sent
through the mail. When these are received, they are deposited in the bank. These checks will be
cleared for the company's use after several days. Checks issued by customers from distant areas
require longer clearing period. This time lag stated briefly, consists of two identifiable periods:
(1) the mail traveling time of the check payment; and (2) the check clearing time.
Various solutions are offered to improve the set-up. To shorten the time lag, some companies
open accounts with banks locate the far-flung areas where the company's branches are located.
The banks serve as the collecting arm of the companies. In most ca this improvement reduces to
half the number of days spent between actual payment made by the client and the availability of
system payment for use by the firm.
Improved Cash Flow Forecasting. A cash flow forecast with high degree of precision and
reliability provides the firm with realistic approaches to planning and budgeting. The
disadvantage of cash excess and cash shortages are eliminated if not minimized
The advantages brought by an improved cash flow forecast are the following:
1. Surplus funds are more fully invested;
2. Alternative methods of meeting the outflows can be explored; and
3. The creation of special reserves for major future outlays will be minimized
Defining and Quantifying the Liquidity Reserve Needs of the Firm. Firms are faced with a
number of uncertainties and contingencies which may require cash reserves. To be protected
against the worst possibilities, a very large reserve of cash will be needed. The idea is to avoid
unnecessary losses or expenditures brought about by liquidity problems. The holding of cash
reserves, however, entails cost. The management is left with striking a reasonable balance
between the two requirements. Several steps are necessary to accomplish this objective. These
are the following:
1. Identification of contingencies requiring protection;
2. Assessment of the probabilities of the contingencies occurring:
3. Assessment of the probabilities of the contingencies occurring at the same time; and
4. Assessment of the probable amount of cash required each of the contingencies happens.
If reserves for certain contingencies will not be provided, the amount of possible losses must be
ascertained. If reserves will provided, the cost of carrying the reserves must also be determined
The expected value of the losses and cost must be computed. This may be arrived at by
multiplying the losses or cost with probability estimates of occurrence.
To illustrate, assume that a labor strike happening in the premises of the company will paralyze
operations. Borrowing funds to cover the necessary expenditures of the firm will penalize the
firm with interest charges amounting to one million pesos. It has also been ascertained that if a
reserve fund has to be carried for the contingency, the firm will be penalized with eight thousand
pesos in the form of lost income which could have been otherwise earned by the idle cash
reserve.
If the probability of the strike happening is placed at 50%, the expected values of the options
may be computed as follows:
Option:
No Reserve
With cash reserve
Penalty:
No reserve P1,000,000
With cash reserve P800,000
Probability:
No reserve 50%
With cash reserve 50%
Expected value:
No reserve P500,000
With cash reserve P400,000
Carrying a cash reserve in this case is more economical to the firm because it carries a lower
penalty expected value.
Development of Alternative Sources of Liquidity. Once the liquidity reserve needs of the firm
have been defined and quantified, alternative sources of meeting these needs should be identified
and evaluated.
One possible alternative is the exploitation of the unused borrowing capacity of the firm.
Borrowings, oftentimes, provide the funds necessary for liquidity: Not all companies, however,
may avail this option. During recession, when small companies are unable to borrow money
from lending institutions, interbusiness financing refers to credit flowing from a large business to
small business.
Search for More Productive Uses of Cash Surplus. Cash surplus may be utilized by the firm to
earn higher returns. A gap may exist, however, between the time when cash starts coming in and
the time it is actually made more productive. As various investment opportunities may be
available, it is important sufficient effort is expended in the determination of the alternative.
Planning activities must also be geared to eliminating the unproductive or less productive gap.
Inasmuch as new investment opportunities may be m available from time to time, a continuous
search and evaluation activity must be done.
Accounts Receivable Management
As sales on account cannot be avoided most of the tin management must face the difficulty
squarely and make it work the advantage of the firm. This is important because when accounts
receivables are not properly managed, the financial viability of the firm may be impaired.
Objectives. One of the goals of business finance is to maximize profitability. In this regard, all
activities of the firm must contribute towards the attainment of this objective.
The purpose of credit extension to clients is to maximize sales Thus, if more sales is required by
the firm, more credit is extended. Increased sales, however, is not an end in itself. Any advantage
gained in extending credit to customers may be offset or even surpassed by problems brought
about by bad-debt losses and the consequent tie-up of funds in receivables.
The objective of accounts receivable management is to determine the cost and profitability of
credit sales. There is no point in extending credit to customers if this will cause a lowering of the
firm's return on investment
The second objective of accounts receivable management is the projection of cash flows from
receivables. This will provide an essential input in the preparation of the firm’s financial plan.
The third objective relates to the direction and control of activities involved in the extension of
credit to customers.
Elements of the Cost of Credit. The cost of credit is compos three elements: (1) bad debts cost:
(2) cost of invested run (3) administrative costs.
Bad debts cost refers to accounts receivable uncollected and subsequently written off. The cost
of invested funds refers to the rate at which the firm could borrow funds to finance credit sales.
These include form letter, individually written letters, telephone charges, clerical and
administrative time spent on an account, and credit and investigation expenses.
Functions of the Credit Department. The credit department performs the following functions:
1. gathering and organizing of information necessary for decisions on the granting of credit
to particular customers;
2. assuring that efforts are made to collect receivables when they become due; and
3. determining and carrying out appropriate efforts to collect accounts of customers who
cannot or do not intend to pay.
Sources of Credit Information. A variety of sources may be used to obtain credit information
concerning customers. The sources most commonly used are the following:
1. personal interviews;
2. references;
3. credit bureaus;
4. credit-reporting agencies, and
5. banks.
Personal interviews provide basic information concerning an applicant for credit. The applicant
is usually required to fill up a credit application blank. The credit application contains the
following items:
1. the name of the applicant;
2. residence and former address;
3. occupation or business,
4. business address
5. bank where the applicant maintains an account, and
6. property owned.
More Information is usually required if the credit applicant is at company. References also
provide a valuable source of inform The credit applicant is usually required to u three credit
references. These references, in turn, may pre valuable insights into the character and ability of
the applicant.
Credit bureaus are institutions organized for the exchange ledger information among associated
creditors. Among the service rendered by credit bureaus are the following:
1. reports;
2. bulletins;
3. credit guides, and
4. special services
Credit reporting agencies consist of more specialized forms credit bureaus. Banks constitute a
valuable source of credit information This is largely due to their involvement in lending
activities.
Evaluation of Credit Risk. Before credit is granted, the risk involved is evaluated. This is done
after information regarding the credit risk has been gathered. In the evaluation of a credit risk,
the basic criteria used refer to the following:
1. Capital;
2 Capacity:
3. Character, and
4. Conditions.
Capital refers to the financial resources of the credit applicant. The balance sheet is a very useful
tool in determining the resources of the applicant.
Capacity refers to the ability of the applicant to operate successfully. This is indicated in the
profit and loss statement of the applicant. Character refers to the reputation for honesty and fair
dealing of the applicant or the owners of the firm applying for credit.
Conditions refer to the environment required for the extension of credit.
Inventory Management
Inventory management refers to the activity that keeps track of how many of the procured items
needed to create a product or service are on hand, where each item is, and who has responsibility
for each item.
Inventory management consists of two aspects: liquidity and profitability. The liquidity story
turnover the profitability aspect is measured in a usually measured in terms of tory level at a
given level of sales and profit
A successful inventory management program's main objective to strike a balance among three
key elements as follows:
1. Customer services
2. Inventory investment in terms of pesos of dollars), and
3. Profit
Customer Service. The period between when the order is made and the date of delivery is very
important to the customer. Shorter periods are preferred. If the customers have to wait too long to
get the products, they will get them elsewhere. The company with the shortest lead time, le, the
number of days the customers have to wait, has a better chance of improving its sales.
Inventory Investment. Funds tied up in inventory should ideally be kept to a minimum without
sacrificing customer service. Investments in inventory eat away company profits. These usually
take the form of interests, insurance, taxes, obsolescence, and storage.
Profit. The level of inventory carried by the company most often affects the profitability of the
company. The task of management is to determine the level which would bring the highest return
on equity
Functions of Inventory. Inventories perform certain functions. These are the following
1. They serve to offset errors contained in the forecast of the demand for the company's products;
2. They often permit more economical utilization of equipment, buildings, and manpower when
the nature of the business is such that fluctuations in demand exists, and
3. It permits the company to purchase or man economic lot sizes.
Forms of Inventory. Inventories are composed of forms which are as follows:
1. raw materials:
2. work-in-process; and
3. finished goods.

Raw materials consist of all parts, sub-assembly and components purchased from other firms but
not yet put into the manufacturers own production processes. When raw materials and labor
added into the basic raw material inputs, they are combined and transformed into work-in-
process inventories. They become finished goods when they are composed and stocked.
Methods of Achieving Inventory Goals. Inventory goals may be achieved by using any of the
several devices available. These devices are the following:
1. the ABC method;
2. the economic order quantity method;
3. the safety stock; and
4. the anticipation stock.
The ABC method classifies inventory into three categories: A, B. and C for management and
control purposes. Category A may be classified as those comprising a large proportion of the
inventory value, and in which tight control is applied. Category B comprises those accounting for
a substantial part of the total inventory value, requiring less tight control. Category C items are
those that account only for a small proportion of the total inventory value and as a consequence
is the least controlled.
The economic order quantity (ECO) method is used to determine what quantity to order so as to
minimize total inventory costs. The EOQ method involves two major costs:
1. carrying costs (warehouse storage costs); and
2. ordering costs (filling in purchase requisitions).
These two costs tend to offset each other. One reason is that ordering in large quantities allows
volume discounts, but it also involves higher storage costs. To balance these two factors, an
economic order quantity should be determined. The EOQ formula is as follows:
EOQ = the square root of 2 US/CI
where: EOQ = economic order quantity
U = annual usage
S = restocking or ordering cost
C = cost per unit
I = annual carrying cost (expressed as percentage of inventory value)
Thus, if annual usage is 1,000 units, restocking cost is 1,000 cost per unit is P50,000, and annual
carrying cost is 10%, EOQ is;
EOQ= 500 = the square root of 2 x 1,000 x P1,000/P50,000 x 10%
= 20
When conditions are uncertain, safety stocks are needed. Se stocks are that part of inventory used
to absorb random fluctuations in purchases, production, and sales.
Anticipated stock refers to that portion of the inventory used for expected seasonal, cyclical and
secular changes in inventory
SUMMARY
That portion of the total capital of the firm which finance the day-to-day activities is called
working capital, and it is continually circulating
The gross working capital refers to the firm's total current assets. The networking capital is the
total amount of current assets minus current liabilities.
Working capital is needed for the following purposes: (1) replenishment of inventory: (2)
provision for operating expenses; (3) support for credit sales; and (4) provision of a safety
margin.
Working capital must be: (1) adequate to cover all current financial requirements: (2) liquid
enough to meet current obligations as they fall due; (3) conserved through proper allocation and
economical use; and (4) used in the attainment of the profit objectives.
Management must require sufficient amount of funds to cover the cash requirements of the firm.
Cash inflows come from cash sales, collection of accounts receivable, loans, sale of assets
ownership contribution, and advances from customers.