MODULE 2

CHAPTER 3
Functions of Financial Management

Learning Objectives
After studying Chapter 3, you should be able to:
1. Describe the role of Finance Manager in achieving the primary goal of the firm.
2. Understanding how finance fits in the organizational structure of the firm.
3. Enumerate the fundamental activities of the Treasurers and the Controller.
4. Explain how the finance function relates to the other functional areas of a business.
5. Learn the importance of corporate governance in achieving the goals of a business
organization.
6. Appreciate the importance of ethics in finance.

Role of Finance Manager

Having examined the field of finance and some of its more recent developments, let
us turn our attention to the functions of the financial manager.
Figure 3-1 shows the financial manager’s role in achieving the primary goal of the firm.

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 In striving to maximize owner’s or shareholder’s wealth, the financial manager makes
decisions involving planning, acquiring, and utilization funds which involve a set of risk-
return trade-offs. These financial decisions affect the market the value of the firm’s stock
which lead to wealth maximization.
In the short run, many factors the market price of a firm’s shares which are beyond
management’s control. Some of the changes in market price do not reflect a fundamental
change in the value of the firm. In the long run, increased prices of the firm. Hence, financial
decisions making should take a longer-term perspective.
It is the responsibility of financial management to allocate funds to current and fixed
assets, to obtain the best mix of financing alternatives, and to develop an appropriate dividend
policy within the context of the firm’s objectives. The daily activities of financial
management, inventory control, and the receipt and disbursement of funds. Less routine
functions encompass the sale of stock and bonds and the establishment of capital budgeting
and dividend plans.
The appropriate risk-return trade-off must be determined to maximize the market
value of the firm for its shareholders. The risk-return decisions will influenced not only the
operational side of the business (capital versus labor) but also the financing mix (stocks versus
bonds versus retained earnings).

The Finance Organization

The financial management function is usually associated with a top officer of the firm
such as a Vice President of Finance or some other Chief Financial Officer (CFO). Figure 3-2
is a simplified organizational chart that highlights the finance activity in a large firm. As
shown, the Vice President of finance coordinates the activities of the treasurer and the
controller. The Controller’s office handles cost and financial accounting, tax payments and
management information systems. The Treasurer’s office is responsible for managing the
firm’s cash and credit, its financial planning, and its capital expenditures.

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RELATIONSHIP WITH OTHER KEY FUNCTIONAL MANAGERS IN THE
ORGANIZATIONAL
Finance is the one of the major functional areas of a business. For example, the
functional areas of business operations for a typical manufacturing firm are manufacturing
marketing and finance. Manufacturing deals with the design and production of a product.
Marketing involves the selling, promotion and distribution of a product. Manufacturing and
marketing are critical for the survival of a firm because these areas determine what will be
produced and how these product will be sold. However, these other functional areas could not
operate without funds. Since, finance is concerned with all of the monetary aspects of a
business, the financial manager must interact with other managers to ascertain the goals that
must be met, when and how to meet them. Thus, finance is an integral part of total management
and cuts across functional boundaries.

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Corporate Governance
Corporate Governance is the process of monitoring managers and aligning their
incentives with the shareholders goals. In reality, because shareholders are usually inactive,
the firm actually seems to belong to management. Generally speaking, the investing public
does not know what goes on at the firm’s operational level. Managers handle day-to-day
operations, and they know that their work is mostly unknown to investors. This lack of
supervision demonstrates the need for monitor. Figure 3-3 shows the people and organizations
that help monitor corporate activities.

The monitors inside a public firm are the board of directors, who are appointed to represent
shareholder’s interest. The board hires the CEO evaluates management, and can also design
compensation contract to tie management’s salaries to firm performance.
The monitors outside the firm include auditors, analysts, investment blanks, and credit
rating agencies. External auditors examine the firm’s accounting systems and comment on
whether financial statements fairly represents the firm’s financial position. Investments
analysts keep tract of the firm’s performance, conduct their own evaluations of the company’s
business activities and report to the investment community. Investment banks, which help
firms access capital markets, also monitor firm performance. Credit analyst examine a firm’s
financial strength for its debt holders. The Government also monitors business activities
through the Securities and Exchange Commission (SEC), Bureau of Internal Revenue (BIR),
Bangko Sentral ng Pilipinas (BSP), and so forth.

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Ethical Behavior
Ethics are of primary importance in any practice of finance. Finance professionals
commonly manage other people’s money. For instance, corporate managers control the
stockholder’s firm, bank employee perform cash receipts and disbursements functions and
investments advisors manage people’s investment portfolios.
These fiduciary relationship oftentimes create tempting opportunities for finance
professionals to make decisions that either benefit the client of benefit the advisors themselves.
Strong emphasis on ethical behavior and ethics training and standards are provided by
professional associations such as the Finance Executive of the Philippines (FINEX), Bankers
Association of the Philippines, Investment Professionals, and so forth. Nevertheless, as with
any professional with millions of practitioners, a few are bound to act unethically. In a number
of instances, the corporate governance system has create ethical dilemmas and has failed to
prevent unethical managers from stealing from firms which ultimately means stealing from
owners or stockholders.
Governments all over the world passed laws and regulations meant to ensure
compliance with ethical code of behavior. And if professionals do not act appropriately,
governments have set up strong punishments for financial fraud and abuse. Ultimately,
financial manager must realize that they owe the owners/shareholders the very best decisions
to protect and further shareholder interests, but they have a broader obligation to society as a
whole.

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 Review Questions and Problems

I. Questions

1. In a large corporation, what are the two distinct groups that report to the chief
financial officer? Which group is focus of corporate financial?
2. Would our goal of maximizing the value of the equity share be different if we
were thinking about financial management in a foreign country? Why or why
not?
3. Why should effective corporate governance be in place?
4. Distinguish the role of an external auditor from the role of an internal auditor.
5. Distinguish the functions of a controller from the functions of the treasurer.

II. Multiple Choice Questions

1. All of the following are functions of the financial manager except

a. Analyzing and planning the company’s performance.
b. Anticipating the company’s financial needs.
c. Assigning the market price of the company’s stock.
d. Allocating focus to the most profitable asset.
2. Which of the following statement is false?
a. The financing decision involves the process of allocating funds for
investment in competing assets.
b. The treasurer would be responsible for activities such as managing cash
balances, granting credit to customers and managing the process of
issuing new securities.
c. The optimal capital structure is the best combination of long-term debt
and equity.
d. It is necessary to determine the appropriate risk-return trade-off to
maximize the market value of the firm for its shareholders.
3. Regine is a financial manager who has discovered that her company is
violating environment regulations. If her immediate superior is involved, her
appropriate action is to
a. Do nothing since she has a duty of loyalty to the organization.
b. Consult the audit committee.
c. Present the matter to the next higher managerial level.
d. Confront her immediate superior.
4. If a financial manager discovers unethical conduct in his/her organization and
fails to act, he/she will be in violation of which ethical standard(s)?
a. “Actively or passively subvert the attainment of the organization’s
legitimate and ethical objectives.”

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 b. “Communicate unfavorable as well as favorable information.”
c. “Condone the commission of such acts by others within their
organizations.”
d. All of the answers are correct.
5. Integrity is an ethical requirement for all financial managers. One aspects of
integrity requires
a. Performance or professional duties in accordance with applicable laws.
b. Avoidance of conflict of interest.
c. Refraining from improper use of inside information.
d. Maintenance of an appropriate level of professional competence.
6. A financial manager discovers a problem that could mislead users of the
firm’s financial data and has informed his/her immediate superior. He/she
should report the circumstances to the audit committee and/or the board of
directors only if.
a. The immediate superior, who reports to the chief executive officer, knows
about the situation but refuses to correct it.
b. The immediate superior assures the financial manager that te problem will
be resolved.
c. The immediate superior reports the situation o his/her superior.
d. The immediate superior, the firm’s chief executive officer, knows about
the situation but refuses to correct it.

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 CHAPTER 4
Forms of Business Organization

Learning Objectives
After Studying Chapter 4, you should be able to:
1. Explain the basic legal forms of business organizations such as, sole proprietorship,
partnership and corporation.
2. Know the advantages and disadvantages of adopting the
a. Sole proprietorship
b. Partnership
c. Corporation form of business organization.
3. Determine the form of business organization most adaptable to an enterprise.

The Organization of the Business Firm

The business firm is an entity designed to organize raw materials, labor, and machines with
the goal of producing goods and /or services. Firms
1. Purchase productive resources from households and other firms,
2. Transform into a different commodity, and
3. Sell the transformed product or service to consumers.

For business firms engaged in retail of trading activities, transforming purchased

goods into a different commodity does not necessarily take place.
Every society, no matter what type of economy it has, relies on business firms to
organize resources and transform them into products. In market economies, most firms choose
their own price, output level, and methods of production. They get the benefits of sales
revenues, but they also must pay the cost of the resources they use.
Business firms can be organized in one of three ways: as a proprietorship, a
partnership, or a corporation. The structure chosen determines how the owners share the risks
and liabilities of the firm and how they participate in making decisions.

LEGAL FORMS OF BUSINESS ORGANIZATION

PROPRIETORSHIP
A sole proprietorship is a business owned by a single person who has complete control
over business decisions. This individual owns all the firm’s asset and is responsible for all its
liabilities. More businesses are sole proprietorship than any form of business organization.
From a legal point of view, the owner of a proprietorship is not separable from the business
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and is personally liable for all debts of the business. From an accounting prospective, however,
the business is an entity separate from the owner (proprietor). Therefore, the financial
statements of the business present only those assets and liabilities pertaining to the business.
The owner cannot be paid salary or wages from the business. Instead, the owner may
withdraw funds or other property from the business. These withdrawals are treated as
reduction of owner’s equity or financial interest of the owner in the business. The business
itself does not pay any income taxes. The income or loss of the business is reported on the
owner’s personal income tax return on a supporting schedule.
Among the advantages of a sole proprietorship are:
1. Ease of entry and exit
A sole proprietorship requires no formal charter and is inexpensive to form and
dissolve.
2. Full ownership and control
The owner has full control, reaps all profits and bears all losses.
3. Tax savings
The entire income generated by the proprietorship passes directly to the owner. This
may be result in a tax advantage if the owner’s tax rate is less than the rate of a
corporation.
4. Few government regulations
A sole proprietorship has the greatest freedom as compared with any form of business
organization.

Major disadvantages of the proprietorship from include:

1. Unlimited liability
The owner is personally liable or responsible for any and all business debts. Thus, the
owner’s personal assets can be claimed by the creditors if the firm defaults on its
obligations.
2. Limitations in raising capital
Fund-raising ability is limited. Resources may be limited to the assets of the owner
and growth may depend on his or her ability to borrow money.
3. Lack of continuity
Upon death or retirement of the owner, the proprietorship cases to exist.
Therefore, the proprietorship may be an ideal form of business organization when the
following conditions exist:

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  The anticipated risk is minimum and adequately covered by insurance.
 The owner is either unable or unwilling to maintain the necessary organizational
documents and tax returns of more complicated business entities.
 The business does not requires extensive borrowing.

PARTNERSHIP
A partnership is a legal arrangement in which two or more persons agree to contribute
capital or services to the business and divide the profits or losses that may be derived
therefrom. Partnership may operate under varying degrees of formality. For example, a formal
partnership may be established using a written contract known as the partnership agreement
which is filed with the Securities and Exchange Commission.
Partnership may be either general or limited.
A general partnership is one in which each partner has unlimited liability for the debts incurred
by the business. General partners usually manage the firm and may enter into contractual
obligations on the firm’s behalf. Profits and asset ownership may be divided in any way agreed
upon by the partners.
A limited partnership is one containing one or more general partners and one or more limited
partners. The personal liability of a general partner for the firm’s debt is unlimited while the
personal liability of limited partners is limited to their investment. Limited cannot be active in
management.
Advantages of a partnership include among others the following:
1. Ease of formation
Forming a partnership may require relatively little effort and low start-up costs.
2. Additional sources of capital
A partnership has the financial resources of several individuals.
3. Managements base
A partnership has a boarder management base or expertise than a sole proprietorship.
4. Tax implication
A partnership like a proprietorship does not pay any income taxes. The income or loss
of the business is distributed among the partners in accordance with the partnership
and each partner reports his or her portion whether distributed or not on personal
income tax return.

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Disadvantages of partnership are:
1. Unlimited liability
General partners have unlimited liability for the debts and litigations of the business.
2. Lack of continuity
A partnership may dissolve upon the withdrawal or death of a general partner,
depending on the provisions of the partnership.
3. Difficulty of transferring ownership
It is difficult for a partner to liquidate or transfer ownership. It varies with conditions
set forth in the partnership agreement.
4. Limitations in raising capital
A partnership may have problems raising large amounts of capital because many
sources of funds are available only to corporations.

CORPORATION
A corporation is an artificial being created by law and is legal entity separate and
distinct from its owners. This legal entity may own assets, borrow money and engage in other
business entities without directly involving the owners. In many corporations, owners who are
also called shareholders do not directly mange the firm. Instead they select managers
designated as the Board of Directors to run the firm for them. The Board of Directors is
authorized to act in the corporation’s behalf.
The incorporation process is initiated by filling the articles of incorporation and other
requirements with the Securities and Exchange Commission (SEC). The articles of
incorporation includes among others the following:
 Incorporators
 Name of the corporation
 Purpose of the corporation
 Capital Stock
 Authorized Shares
After the corporation is legally formed, it will then issue its capital stock. Ownership
of the stock is evidenced by a stock certificate. The corporate by laws which are rules that
govern the internal management of the company are established by the board of directors and
approved by the shareholders. These by laws may be amended or extended from time to time
by shareholder.

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Advantages of a corporation are:
1. Limited Liability
Shareholders are liable only to the extent of their investment in the corporation. Thus,
shareholders can only lease what they have invested in the firm’s shares, not any
personal assets. However, limited liability is not all-encompassing. Government may
pass through the corporate shield to collect unpaid taxes. Also, it is not uncommon for
corporate to require that major shareholders personally co-sign for credit extended to
the corporation. Thus, upon default by the business, the creditors may sue both the
corporation and shareholders who have co-signed.
2. Unlimited Life
Corporations continue to exist even after death of the owners.
3. Ease in transferring ownership
Shareholders can easily sell their ownership interest in the most corporations by
selling their stock without affecting the legal form of business organization. The
ability to sell stock provides corporations with a stronger financial base and the capital
needed for expansion.
4. Ability to raise capital
Corporations can raise through the sale of securities such as bonds to investors who
are lending money to the corporations and equity securities such as common stock to
investors who are the owners.
Disadvantages of a corporation include:
1. Time and cost of formation
Registration of public companies with the SEC may be time-consuming and costly.
2. Regulation
Corporations are subject to greater government regulations than other forms of
business organizations. Shareholders can’t just withdraw asset from the business.
They can only receive corporate assets when dividends are declared and these amounts
may be subject to limits imposed by law.
3. Taxes
Corporations pay taxes on income they have earned. The complexity of the subject of
taxation demands the advice of a qualified tax accountant.
The need of large businesses for outside investors and creditors is such that, the
corporate form will generally be the best for such firms. We focus on corporations in the
chapters ahead because of the importance of the corporate form not only locally but also in
world economies. Also, a few financial management issues, such as dividend policy are unique
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to corporations. However, businesses of all types and sized need financial management, so the
majority of the subjects we discuss bear on any form of business.

REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. What are the three basic forms of business ownership? What are the advantages
and disadvantaged to each?
2. Between the three basic forms of business ownership, describe the ability of each
form to access capital.
3. Explain how the founder of a business can eventually lose control of the firm.
How can the founder ensure this will not happen?
4. Who owns a corporation? Describe the process whereby the owners control the
firm’s management. What is the main reason that an agency relationship exists in
the corporate form of organization? In this context, what kinds of problems can
arise?

II. Multiple Choice Questions

1. One of the major disadvantages of a sole proprietorship is
a. That there is limited liability to the owner
b. The simplicity of decision making,
c. Low organizational costs.
d. Low operating costs.
2. The partnership form of organization
a. Avoids the double taxation of earnings and dividends found in the
corporate form of organization.
b. Usually provides limited liability to the partners.
c. Has unlimited life
d. Simplifies decision making
3. A corporation is
a. Owned by stockholders who enjoy the privilege of limited liability.
b. Easily divisible between owners.
c. A separated legal entity with perpetual life.
d. All of the above.

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