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CHAPTER

1
OVERVIEW OF FINANCE

LEARNING OBJECTIVES

After studying this chapter, you should be able to…

1. define finance;
2. identify the different categories of finance;
3. discuss goals of business finance.

BASIC CONCEPTS

Terms, unless they are clearly defined, are sometimes confusing. As some of them
are related, it is important to define them and discuss their relationships with other
relevant terms.

Finance

Finance may be defined as the study of the acquisition and investment of cash for
the purpose of enhancing value and wealth.

Categories of Finance. Finance, in general, is divided into categories according

to the type of entity or organization served. They are the following:

1. public finance
2. private finance

Public Finance. Public finance is that category of general finance, which deals
with the revenue and expenditure patterns of the government and their various effects on
the economy.

Private Finance. This category deals with the area of general finance not
classified under public finance. It is subdivided into the following:

1. personal finance;
2. the finance of non-profit organizations; and
3. business finance.

Personal finance is concerned with the fundamentals of managing one’s own

personal money affairs. The finance of non-profit organizations includes private
undertakings such as charity, religion, and some private educational institutions.
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DEFINITION OF BUSINESS FINANCE

The term business finance refers to the provision of money for commercial use.
Business finance, however, is more than just the provision of money. It is also concerned
with the effective use of funds. As such, it covers the financial management of private
profit-seeking concerns in the business of service, trade, manufacturing, mining, public
utilities, and financing. With the foregoing requirements, business finance may be
defined as the procurement and administration of funds with the view of achieving the
objectives of the business.

Specially, however, business finance may be concerned with three aspects:

1. small business finance;

2. corporation finance; and
3. multinational business finance.

It must be made clear that there are similarities and differences between the three
aspects of business finance.

Categories of Finance

Finance

Public Finance Private Finance

Personal Finance Business Finance Finance of Non-

Profit
Organization

Small Business Corporation Multinational Business

Finance Finance Finance

THE GOALS OF BUSINESS FINANCE

Private business is established primarily for profit. This end, however, can be
achieved by the effective management of the various business function. One of these is
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the finance functions, it has its own goals. The goals of business finance are variously
expressed as follows:

1. maximizing profit;
2. maximizing profitability;
3. maximizing profit subject to cash constraint;
4. maximizing net present worth; and
5. seeking an optimum position along a risk-return frontier.

Maximizing Profit

Maximizing profit means realizing the highest possible peso or dollar income. A
firm, for instance, may seek to double its peso or dollar income for the current year. This
framework, however, is not very useful in making sound financial decisions. The amount
of profit earned by the firm is not adequate to evaluate its performance. For instance, the
net income earned by XYZ Company for a certain year in the amount of ₱480 million
does not provide much useful information for the investor or financial manager. This is
true even if the same amount represents an increase from previous year’s profits of the
firm.

Maximizing Profitability

When a firm decides on obtaining a higher rate of return on its investment, it is

said to be maximizing profitability. The following data show an improvement in the
company’s performance.

MIKAELA COMPANY
(2006)
2005 2006
Net Worth ₱100,000,000 ₱200,000,000
Net Profit 1,000,000 5,000,000
Return on Investment 10% 25%

Maximizing Profit Subject to Cash Constraint

In the quest for profit maximization, undue emphasis is sometimes placed on cash
balances. Maintaining too large a cash balance reduces the chance of a favorable rate of
return, while running out of cash when needed is disastrous. The ideal set-up is to
maximize profits, while at the same time maintaining a cash balance that can take care of
cash requirements anytime. This condition is especially critical in the operation of banks.
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Maximizing Net Present Worth

Under the net present worth concept, the objective of the firm is to maximize the
current value of the company to its owners. The net present worth of the firm is equal to
the value now of the firm plus values arising in the future. The present worth of values
arising in the future are computed and added to the present worth of the other values of
the firm. Present values may be better understood by way of knowing the concept of the
time value of money.

Time Value of Money. This concept indicates that money increases in value with
the passing of time. A peso today could be deposited in a bank and made to earn interest.
This capacity to earn makes the peso today worth more than the peso that would be
received in the future. Thus, to be able to find out the present worth of a peso that would
be received in the future, the corresponding interest (or discount) should be deducted
from that the future peso.

Calculation of Present Worth. The present worth of a value to be received in the

future is illustrated as follows:

Question: What is the value today of ₱100,000 to be received next year assuming
that the prevailing rate of interest in ten percent (10%) per annum?

Solution:

Value today = amount ₱100,000

of next year’s = = ₱90,909.09
₱100,000 1 + rate of interest 1.10

Seeking an Optimum Position Along a Risk-Return Frontier

A firm can set a goal of achieving the best possible combination of risk and
return. A little more risk may be accepted, for instance, for an expected additional rate of
return.

Definition of Return on Investment or Net Worth. The net income generated

by the use of investments or the net worth of a firm is referred to as return on investment.
When it is expressed in percentage, it is called the rate of return.

Definition of Risk. Uncertainty as to loss called risk. When used in finance, the
term applies to the potential incurrence of loss of money or its equivalent. Risk is
discussed at length in a succeeding chapter.
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Calculation of Expected Value Using Risk and Return Factors. The optimum
position of risk and return may be determined by calculating the expected value of
alternative decisions. The expected value of a return on investment is equal to the return
times the percentage of probability that it will happen (called the risk factor). An
illustration is provided as follows:

Alternative Return on Net Probability Expected Value

Worth
(A) (B) (A x B)
1 ₱100 million 60% ₱60 million
2 ₱200 million 50% ₱100 million
(optimum position)
3 ₱300 million 30% ₱90 million

FUNCTIONS OF BUSINESS FINANCE

Business finance is both an art and a science. It is concerned with allocating the
financial resources of the company; procurement of funds needed; and the efficient and
effective utilization of these funds.

In allocating financial resources, it is important that funds are channeled to

activities that are profitable or costs are minimal. Possible risks are losses which may
arise from decline in property value. Procurement of funds requires that capital sourcing
must be done at the least cost possible. This involves evaluation of the different sources
of funds and the cost involved. Sources available can be short-term and long-term funds.
Cost of capital maybe in the form of financing charges, such as interest, service charges.
For capital contribution of owners, costs are the dividends or shares in profit of the
stockholders. For the efficient utilization, funds must be used for purposes which they are
intended. Unnecessary expenses, unproductive labor, so much investment in fixed assets
may involve inefficiency in utilizing resources. Effective use of resources require
periodic assessment of operations if they are consistent with the company plans, in
attaining its short-term and long-term goals. This needs periodic review of operations to
check on developments and to identify remedial or corrective actions when necessary.

It is unwise to have excessive balance of cash, receivables, inventories and other

financial resources. The company, in this case, will lose opportunities to earn on capital
tied up or on idle funds. Idle cash may be invested in short-term placement. Too much
receivables can lead to more collection costs and greater risk for bad debts. Inventories,
beyond what is in demand, may increase handling and storage costs, or obsolescence.
Plant, property and equipment, more than what the company needs, gives the company
more expenses for repairs, maintenance and depreciation.
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QUESTIONS FOR REVIEW AND DISCUSSION

1. What is meant by finance?

2. Distinguish private finance from public finance.
3. Define the term business finance.
4. A farmer borrows funds from a government financing institution. In turn, he uses
the funds for producing palay. Do you consider this activity as business finance?
Why or why not?
5. What are the goals of business finance?