MODULE-FM-203-FINANCIAL-ANALYSIS-AND-REPORTING.pdf

MODULE FOR FM 203 FINANCIAL ANALYSIS AND REPORTING ZORCASTRO E. CABELLO, MBA Instructor – AY 2023-2024  CHAPTER I – INTRODUCTION: THE FINANCE FUNCTION Learning Objectives: Define business finance, EPS, growth of a business firm, stability of a busine...

MODULE FOR FM 203 FINANCIAL ANALYSIS AND REPORTING ZORCASTRO E. CABELLO, MBA Instructor – AY 2023-2024  CHAPTER I – INTRODUCTION: THE FINANCE FUNCTION Learning Objectives: Define business finance, EPS, growth of a business firm, stability of a business firm, portfolio, working capital, social involvement of businessmen and multiplier effect of a business. Enumerate and explain the primary goals of a business. Summarize the significance of owners’ equity. Enumerate and explain the primary activities of the financial manager. INTRODUCTION: THE FINANCE FUNCTIONS An organization, whether political, civic or business in nature, must be aware of its immediate and future requirements for funds, the possible source thereof and the benefits that may accrue to the organization itself and to the community arising from efficient and effective utilization of said funds. PRIMARY GOALS Going into business means investing in activities that can make available goods and services needed in a community, realize profit from investments, increase the value of the business itself as an economic entity, and improve the quality of life in the community. In other words, we fill an economic need, gain therefrom and at the same time, contribute to the economic and social well-being of the people in the locality. Inasmuch as a business concern is, in itself, an economic entity, its growth and stability enhance also the economic condition of the community where it is stipulated. The primary goals of a business concern must therefore be as follows: To earn profit To increase its own value as an economic entity To improve the quality of life in the community TO EARN PROFIT Funds are invested in a business to earn sufficient return on investment. Goods and services are made available to the public and are billed to customers/clients with sufficient markup to cover operating expenses, financing charges, income taxes and desired net profit. Earnings Per Share. This refers to how much net income is earned for every share of capital stock outstanding. This is the summary figure that investors use in evaluating past performance of a business firm. The simplest formula for EPS is given below: EPS = Net Income related to Common Stock / Weighted Average Number of Shares Outstanding of Common Stock In general, the higher the EPS, the higher is the price a stock can command in the market. INCREASING THE VALUE OF A BUSINESS Growth and stability are the primary bases in measuring the value of a business entity. Growth may be measured in terms of increase in assets that appreciate in value, improved production capacity accompanied by increase in sales volume and increase in owners’ equity. Profitability contributes to growth and stability especially when part of realized profit is retained or plowed back into the business. Stability of a company refers to its ability to weather the ups and downs in the economy or its ability to continue operations despite anticipated risks in a business. It is measured primarily based on the relative amount of owners’ equity. The measures of stability include the debt/equity ratio, the equity/debt ratio, and the number of times a company earns an amount equal to its total fixed charges. Owners’ equity is the difference between total asset and total liabilities of an entity so that it is also called net assets or net asset value (NAV). Its primary source is the owners’ investment or capital placed in the business to which realized profit or net income is added. It is reduced by losses and distribution of earnings (called dividends in the case of corporations). It is considered as the margin of safety to creditors because it is the amount by which assets may be decline in value and still enable to pay the claims of its creditors. Thus, if total assets amount to 300,000 and liabilities are 180,000, owners’ equity ought to be the difference of 120,000. The assets may decline in value by 120,000 and still, the business would be in the position to pay its debts. It therefore follows that the greater is the owners’ equity, the more stable in a company is and the higher is the price that its owners can demand for their share in equity should they decide to dispose or sell the same. For corporations, the owners’ equity or stockholders’ equity is divided by the number of shares of capital stock outstanding to arrive at the book value per share. This serves as one of the bases in determining management’s performance and for investors, in determining what price to pay for the shares of stock of a company. SOCIAL RESPONSIBILITY OF BUSINESSMEN The social responsibility of a businessmen refers to his contribution to the improvement of the quality of life in the community. This is not in the form of pecuniary contributions but more on how his business is able to improve the economy and its environment. He adheres to legal and moral standards by adopting company objectives, policies and practices consistent therewith. Multiplier Effect of a Business in a Community. This refers to the chain effects of business activities. They affect not only the earning power of people directly involved with it (such as the employees, suppliers and customers) but also those indirectly affected by its economic activities. All these bring about increased demand for other products and services. Thus, multiplier effect of a business is geometric or exponential in nature. CONCEPT AND FUNCTIONS OF BUSINESS FINANCE Finance has been defined as the art and science of managing money. Inasmuch as most business transactions affect the financial resources of a company, business finance, may be defined as the art and science in managing the financial resources of a business. As such, it is concerned with allocation, procurement, and efficient utilization of financial resources to enable a business concern to attain its predetermined objectives relative to growth, stability, profitability and liquidity. It involves determination of the requirements for funds, making funds available at the least cost and seeing to it that funds are being used as planned so as to optimize operations and increase the value of the business itself and consequently, to enable the business to contribute to the economic growth of the community and the social well-being of its population. The following are the functions of business finance: Allocation of financial resources Procurement of funds Efficient and effective utilization of financial resources ALLOCATION OF FINANCIAL RESOURCES In accordance with a company’s financial objectives and standards, projects or activities and operations are carefully planned, evaluated based on certain criteria, and subsequently ranked for the allocation of financial resources. The objective is to be assured that funds are channeled to activities that are considered profitable and/or will increase the value of the business itself and that company costs and risks are minimized. The following are some of the questions asked in evaluating project proposals: Is the project necessary? What is its social relevance? Are there other alternatives? How will the proposal affect our current operations? What resources of the company (labor force, plant, property and equipment, etc.) can be used in the project? How much is the estimated capital requirement?  What is the economic life of the project (or its number of years of operations)? How much are the estimated cash returns? How long will it take to recover our investment or what is the payback period? What is the rate of ROI? Is the rate of return higher than the cost of capital to be used? What are the risks involved in the proposal? The riskier a project is, the higher is the standard set as minimum desired rate of ROI. Thus, if a company desires a 30% rate or return on its investments, it may add, say 5% or more for risky project proposals so that the latter must have a rate of return of at least 35% to meet the rate of return criterion. Risks may be in the form of possible losses arising from decline in revenue, rise in operating costs and expenses, and decline in property value. PROCUREMENT OF FUNDS Capital must be made available at the least cost when it is needed. The procurement function requires awareness of the different sources of funds and the cost involved. There are short-term and long-term sources of funds with varying requirements and conditions. Cost of capital varies with the sources thereof. On borrowed funds, it is in the form of financing charges (interest, commissions, and service charges). On capital contributed by owners or stockholders, the corresponding cost is in the form of dividends or shares in profit. To be assured that repayments of capital used and the corresponding costs involved can be made from cash returns from company projects, the repayment period should be longer than the economic life of the latter. It can also be done by seeing to it that the periodic cash returns exceed the required repayments. EFFECTIVE AND EFFICIENT UTILIZATION OF FINANCIAL RESOURCES Efficient utilization of financial resources refers to their economical use. In other words, we see to it that financial resources are actually being used for what they have been intended. Inefficiency in the use of financial resources may be caused by extravagance in the choice of property and equipment, unnecessary expenditures, tardiness of personnel and non-productive resources. Effective utilization of financial resources refers to their use towards the attainment of predetermined objectives. This requires a periodic review of operations to determine whether they are in accordance with plans and whether the plans, as prepared, will enable the company to attain its short-term goals and long-term objectives considering the changes in the economic environment. Financial resources must be utilized in a manner that minimizes company costs arising from wastages and lost opportunities due to delays in operations and idle or non-productive resources. It requires adoption of effective control measures. When approved projects are already in operation, there should be constant follow up by observation, inspection, periodic review of operations with use of progress reports and comparison between plans and operations so that prompt remedial or corrective measures may be adopted. INVESTMENT PORTFOLIO The term portfolio refers to a brief case that is normally being used in carrying business papers and documents. Because of this, the term came to be used as referring to the aggregate of assets held as investments by an organization or individual. A business organization or an individual may maintain investments in stocks, bonds, money market placements, real estate and precious stones and metals. Some of these are maintained because of their periodic earnings, some are for their increase or appreciation in value, and some are maintained for both. They are so managed to maximize their aggregate value to the extent that investment analysts are hired to determined when the company should invest more in one or two of them and when the investment should be transferred to other items. THE FINANCIAL MANAGER: HIS PRIMARY ACTIVITIES In as much as business finance is concerned with the management of the financial resources of a company and financial resources refers to all the resources of a company that are measurable in terms of the monetary unit, the primary activities of the financial managers must concern the different items included in the balance sheet. Thus, his primary activities must be (a) financial planning and analysis, (b) managing the firm’s assets and (c) managing the firm’s liabilities and owners’ equity. The financial manager in a business organization is not always called as such. His title varies depending on the size and organizational setup in a company. In small business firms, the finance functions are discharged by the sole proprietor, the accountant and the manager. As the organization grows bigger, the organizational setup becomes more sophisticated so that we may have the finance functions delegated to the controller and/or treasurer. In some cases, there is a vice president for finance to whom the controller and the treasurer report. The finance functions are usually divided between the controller and the treasurer as follows: CONTROLLER TREASURER Determination of financial requirements and Planning for control which includes budgeting. procurement of funds. Reporting and interpreting results of operations Cash management, banking, custody of funds, and systems installation. and foreign exchange problems. Evaluation of objectives, policies, and procedures and consulting with all segments of Investor relations. management regarding the same. Tax administration and government reporting. Corporate investments. Protection of assets. Credit and collections. Economic appraisal (forward planning). Insurance Employees’ benefits.  CHAPTER II – ORGANIZING A BUSINESS; FORM OF BUSINESS ORGANIZATION Learning Objectives: Define entrepreneurship, promotion, feasibility study, sole proprietorship, partnership, corporation, pre-emptive rights of the stockholders, common stock, preferred stock, par value stock, dividends, stock dividend, scrip dividend, liquidating dividend and other terms given in the chapter. Enumerate the following: The different activities involved in promotion; Major parts of the feasibility study; Advantages and disadvantages of a sole proprietorship, a partnership and corporation; Classes of partnerships and corporations Differences and similarities between partnerships and corporations. Compute for the following: The number of directors one can vote for based on the number of shares of stock owned and vice versa; The effect on proportionate interest when pre-emptive right is exercised and when not exercised. State the limitation to retention of corporate earnings as provided in the Corporation Code of the Philippines. ORGANIZING A BUSINESS Many individuals would want to go into business on their own but are hesitant to do so. Oftentimes, they start small and gradually improve operations and consequently, their financial position. However, the longer one engages in business, the more he realizes that there are greater opportunities for growth and profit. They may be beyond his limitations so that he opts to modify they type of his organization. ENTREPRENEURSHIP The term entrepreneurship refers to an individual’s undertaking whereby he invests his money in a business which he engages. When a man decides to go into business, it must be his ambition to be his own master and employer. He must be willing to give up the complacency of an eight-to-five employee who receives his paycheck regardless of typhoons, drought etc. He must have sufficient knowledge of management organization, finance and the related field of study. He must have the ability to take advantage of opportunities and the willingness to take risks. He must be innovative. FORM OF BUSINESS ORGANIZATIONS A business organization may be in the form of sole proprietorship, partnership, or corporation. A sole proprietorship is a form of organization where there is only one owner, the proprietor. A partnership is an association of two or more persons who bind themselves to contribute money, property, or industry to a common fund, with the intention of dividing profits among themselves. A corporation is an artificial being created by operations of law, having the right of succession and the powers, attributes and properties expressly authorized by law or incident to its existence. SOLE PROPRIETORSHIP Many small businesses in the Philippines are started as sole proprietorships. This is often due to the desire of an individual who is going into business for the first time, to do it on his own first while learning the trade. After operating for some time, he invites or gets invited to form a partnership or a corporation. ORGANIZING A SOLE PROPRIETORSHIP The following is the procedure followed in organizing a sole proprietorship:  Register the business name with Department of Trade and Industry; Pay the municipal license to the LGU. Apply for VAT or non-VAT number. Register with BIR the books of accounts (simplified bookkeeping records or journals and ledger) and the business forms to be used (sales invoices, cash sales invoices, official receipts, etc.) It should be emphasized to anybody desirous of going into business that unless the business activities he has in mind require an office or store, he can do business in his own residence. ADVANTAGES AND DISADVANTAGES OF A SOLE PROPRIETORSHIP Each type of organization has its advantages and disadvantages. For a sole proprietorship, they are as follows: Advantages Disadvantages It is easy to organize. The governmental Limited ability to raise capital. The requirements for sole proprietorships are business depends only on the financial minimal. resources that can be procured by the sole owner. Decisions can easily be made inasmuch as The sole proprietor has unlimited liability. they are made by the owner himself. Business creditors can go after his personal assets to satisfy their claims. Financial operations are not complicated Limited ability to expand. This is due to its inasmuch as this type of organization is limited capital and in most cases, generally for small-scale business. operations are limited only to areas in which the sole proprietor has expertise. The owner is entitled to all profits his Business is entirely a responsibility of the business realizes. owner. The owner has nobody to share with the burden of decision making and losses he might incur. Net income is subject to tax regardless of whether it is withdrawn or not. It may be noted that the disadvantage of having limited ability to expand (third bullet) arises from the limited liability to raise capital (first bullet). For anyone intending to go into business, capitalize on the advantages as listed and invest the minimum amount of capital required to make the business viable. The perennial advice of “not putting all your eggs in one basket” may be observed by channeling remaining resources to other forms of investment to provide leverage. PARTNERSHIPS Partnerships are governed by the provision of the Civil Code, articles 1767-1867. A partnership is defined as an association of two or more persons who bind themselves to contribute money, property, or industry to a common fund with the intention of dividing the profits among themselves. It begins to exist from the moment of the execution of the partnership contract, unless it is otherwise stipulated. ORGANIZATION OF PARTNERSHIPS A partnership, in its simplest form, is formed when an individual invite another to join him in business and divide profits between themselves. In some cases, existing sole proprietorships combine their businesses and even invite other individuals to a partnership. As a general rule, no special form, is required for the validity or existence of the partnership contract so that it may be made orally or in writing regardless of the value of the contribution. When immovable property or real rights are contributed, the contract must be in a public instrument. PROVISIONS OF THE CIVIL CODE ON PARTNERSHIP FORMULATION Article 1771. A partnership may be constituted in any form except where immovable property or real rights are contributed thereto, in which case a public instrument shall be necessary. Article 1772. Every contract of partnership having a capital of 3,000.00 or more, in money or property, shall appear in a public instrument, which must be recorded in the Office of the Securities and Exchange Commission (SEC). Failure to comply with the requirement of the preceding paragraph shall not affect the liability of the partnership and the members thereof to the third parties. Although the Civil Code requires that every partnership contract with capital of 3,000.00 or more to be in a public instrument and registered with the SEC, failure to comply with the said requirement does not affect its validity. However, the registration with the SEC is a requirement for the issuance of licenses by the municipal or city government. The following is the procedure followed in organizing a partnership: Register the business name with the Bureau of Domestic Trade or DTI. Have the partnership agreement (articles of partnership) (notarized). Obtain a tax account number for the partnership from the BIR. Have the partnership agreement (articles of co-partnership) notarized and then registered with SEC. Obtain the municipal licenses from the local government. Obtain the value added tax account number (VAT) or the non-VAT, as the case may be. Register books of accounts (journals and general ledger) and business forms to be used (sales invoice, official receipts, cash sales invoices, etc.) with BIR. PARTNERSHIP CONTRACT The contract between the partners is called the articles of co-partnership. It contains, among other items, the following: Nature of the partnership Names of the partners Place of business Effective date of the partnership Nature of business Investment of each partner and corresponding capital credit Duration of the contract Rights, powers, and duties of the partners Accounting period Manner of dividing profits and losses Liabilities of the partners for partnership debts Compensation for services offered by partners Treatment of partners’ additional investments and withdrawals Procedures for settlement of partner’s interest upon dissolution of partnership Provision for settlement of disputes. CLASSIFICATION OF PARTNERSHIP Partnership may be classified based on object or scope of subject matter and based on liability of partners for partnership obligations. Based on object or scope of subject matter: a. Universal partnership. This may refer to the contribution by partner of all present property or of all profits. Universal partnership of all present property. This may refer to all the properties that actually belong to each of the partners at the time the partnership is formed, with the intention of dividing the same among themselves as well as the profits that they may acquire therewith.  Universal partnership of all profits. This refers to all the profits that the partners may acquire by their industry or work during the existence of the partnership. b. Particular partnership. Its objects are determinate things, their use or fruits, or a specific undertaking, or the exercise of a profession or vocation. Based on liability of partners for partnership obligations: a. General partnership. In this kind of partnership, all the partners are general partners (or partners liable for partnership debts to the extent of their personal property after all the partnership assets have been exhausted). b. Limited partnership. This refers to partnership having one or more general partners and one or more limited partners (or partners who are liable for partnership debts only to the extent of their capital contributions). CLASSES OF PARTNERS Partners may be classified based on their contribution and based on their liability for partnership debts. Based on their contribution: a. Capitalist partner. He is a partner who contributes money or property to the capital of the partnership. b. Industrial partner. He is a partner who contributes his work, labor or industry to the partnership. c. Capitalist-industrial partner. He is one who contributes money or property as well as his work or industry to the capital of the partnership. Based on their liability for partnership debts: a. General partner. He is one who is liable for partnership debts to the extent of his personal property after partnership assets are exhausted. b. Limited partner. He is one whose liability for partnership debt is limited to his capital contribution. PARTNERSHIP AS A JURIDICAL PERSON Per Article 1768 of the Civil Code (this partnership has a juridical personality separate and distinct from that of each of the partners even in case of failure to comply with the requirements of Article 1772, first paragraph), a partnership has a juridical personality separate and distinct from that of each of the partners even if the contract between the partners is not in a public instrument and is not registered with the SEC. as such, the partnership can acquire and possess property of all kinds, as well as incur obligations and bring civil or criminal actions in conformity with laws. RESPONSIBILITIES OF PARTNERS Every partner is an agent of partnership so that every act of his, including the execution of any instrument in the partnership name, for apparently carrying partnership business in the usual way, binds the partnership. An exception to this is when the partner so acting has in fact no authority to act for the partnership in the particular matter and the person with whom he is dealing knows that he has no such authority. With respect to contribution of property, Article 1786 of the Civil Code states: Every partner is debtor is debtor of the partnership for whatever he may have promised to contribute thereto. He shall also be found for warranty in case of eviction with regard to specific and determinate things which he may have contributed to the partnership, in the same case and in the same manner as the vendor is bound with respect to the vendee. He shall also be liable for the fruits thereof from the time they should have been delivered without the need of any demand. MANNER OF DIVIDING PROFITS AND LOSSES Partnership profits and losses are divided based on the agreement between themselves. In the absence of stipulation in the partnership contract, the same shall be divided based on their capital contributions. An industrial partner shares in profits based on what may be just and equitable under the circumstances. He is given priority in the division of profits and he does not share in losses. If besides his services, he contributes capital so that he in effect, is an industrial-capitalist partner, he shall also receive a share in the profits in proportion to his capital. LIABILITY OF INCOMING PARTNER FOR EXISITING OBLIGATIONS An incoming partner has limited liability for all obligations existing at the time of his admission to a partnership. Article 1826 of the Civil Code states: A person admitted as a partner into an existing partnership is liable for all the obligations of the partnership arising before his admission as though he had been a partner when such obligations were incurred, except that this liability shall be satisfied only out of partnership property, unless there is a stipulation to the contrary. ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP The following are the advantages and disadvantages of partnerships: Advantages Disadvantages It is easy to form. This is because the Partners have unlimited liability for partnership is subject to less legal partnership debts. requirements. Flexibility of operations. Its choice of It has limited life because it can easily be activities is not subject to so many dissolved. A partnership, being a contract restrictions. Inasmuch as there generally between the partners is dissolved based on are few owners in a partnership, an their agreement, and upon the withdrawal, agreement among partners can be easily incapacity or death of a partner, etc. arrived at without unnecessary delay. It is expected to be operated more Limited liability to raise capital. The efficiently when compared with a sole amount of capital depends on how much proprietorship because of the presence of can be contributed and/or procured by the more owners. In other words, “two heads partners. are better than one”. Partners are expected to have great interest Net income is subject to tax whether in the operations of the partnership because distributed or not. All partnerships, except of their unlimited liability for partnership general professional partnerships, are debts aside from their shares in profits. subject to the corporate tax rate. ORGANIZATIONAL SETUP IN A PARTNERSHIP A partnership usually has a managing partner appointed in the articles of partnership. A managing partner has all the powers of a general agent as well as all the incidental powers necessary to carry out the object of the partnership in its operations. In case the partners fail to designate who among them shall act as manager, all of them shall be considered as agent of the partnership. CORPORATIONS Private corporations are governed by the Corporation Code of the Philippines, per Batasang Pambansa Blg. 68. CORPORATION DEFINED Section 2 of the Corporation Code states: A corporation is 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. An artificial being, a corporation is a legal or juridical person with a personality separate from its individual stockholders or members. Because of this legal concept of a corporation, it may acquire and possess property of all kinds, incur obligations, and bring civil or criminal actions in the same manner as a natural person does. Its juridical personality begins to exist from the date of the issuance of Certificate of Incorporation by SEC under its official seal. THE RIGHT OF SUCCESSION A corporation has the right to continuous existence irrespective of death, withdrawal, insolvency, or incapacity of the individual members or stockholders and regardless of the transfer of their interests or shares of stock. Its life is limited to the term stated in the articles of incorporation but it should not exceed 50 years, subject to extension for a period not longer than 50 years in any one instance. CLASSIFICATION OF CORPORATIONS a. Based on the nature of capital Stock corporation. Capital is in the form of capital stock divided into shares. Corporate earnings may be distributed to shareholders as dividends. Non-stock corporation. This refers to a not-for-profit organization and organized for the benefit of its members or its intended beneficiaries. It is formed for educational, professional, charitable, religious, scientific, social, civic, fraternal or literary services or similar purposes such as trade, industry or agricultural chambers or any combination thereof. It uses fund accounting so that the balance sheet equation is: ASSET = LIABILITIES + FUND BALANCE. b. Based on ownership Government owned or controlled corporation (GOCC). It is either owned or controlled by the government. Non-government corporation Public company. The SEC’s Code of Corporate Governance defines a public company as any corporation with a class of equity securities listed in an Exchange or with asset in excess of 50,000,000.00 and having 200 or more stockholders each holding at least 100 shares of a class of its securities. Non-public corporation. One that does not qualify as public corporation per requirements given in a above. (It may also be called private. However, all companies registered with the SEC are private). c. Based on its relation to another corporation Parent corporation. It owns the controlling interest of more than 50% in another corporation. Subsidiary corporation. The investee corporation in which the investor corporation has controlling interest. The controlled corporation is called a subsidiary. Associate. The investee corporation in which the investor corporation has significant influence (not controlling interest). In the absence of any evidence to the contrary, significant influence is assumed to exist when there is ownership of 20% or more but not exceeding 50%. When the ownership exceeds 50%, it is already considered as controlling interest. d. Based on the country or by whose laws they have been created Domestic corporation. It was incorporated under Philippine law. Foreign corporation. It was incorporated under the laws of a foreign country. e. Based on who are accepted as shareholders or members Close corporation. It is limited to selected persons or members of a family. Open corporation. It is open to any person who may wish to become a shareholder or member thereof. COMPONENTS OF A CORPORATION The following are the terms used for persons composing a corporation. Corporators. This term refers to all the persons composing a corporation whether they are stockholders (in the case of stock corporations) or members (in the case of non-stock corporations). Incorporators. This refers to corporators who are mentioned in the articles of incorporation as originally forming and composing the corporation and who executed and signed the articles of incorporation as such. Sec. 10 of the Corporation Code states: Any number of natural persons not less than five (5) but not more than fifteen (15), all of legal age and a majority of whom are residents of the Philippines, may form a private corporation for any lawful purpose/s. each of the incorporators of a stock corporation must own or be a subscriber to at least one (1) share of the capital stock of the corporation. Stockholders. This term refers to natural or juridical persons who own at least one (1) share of the capital stock of a corporation. Member. They are the corporators in a non-stock corporation. Board of Directors or Trustees. This is the governing body in a corporation. With the exception of some powers reserved by law to stockholders (or members), the board of directors has the sole authority to determine the policy and conduct the ordinary business of the corporation within the scope of its charter. A director must have at least one (1) share of capital stock registered in his name at the time of his election (or required cut-off date) and during his term. For a non-stock corporation, the body is usually called the Board of Trustees. CORPORATE FORMATION Corporate formation requires all the activities that must be undertaken in preparing a business and in complying with all the legal requirements for the entity to have its legal personality as corporation. The promoters sell the idea of forming a corporation to other people who may agree to become incorporators and/or provide capital, rights and property necessary to achieve the corporate purpose/purposes. They have to open bank accounts, conduct regular meetings between the incorporators, and contract people for services such as feasibility studies and preparation of legal documents, particularly, those required by the SEC. the costs incurred in corporate formation are charged to an account, Organization Costs. REGISTRATION OF CORPORATIONS Registration of corporation involves the following procedure: 1. Verification of corporate name with SEC. This is to determine if the corporate name to be adopted has already been adopted by any other firm whether partnership or corporation duly registered with SEC. 2. Drafting and execution of the articles of incorporation. 3. Deposit of cash received for subscribed shares of stocks in a banking corporation in the name of the temporary treasurer, in trust for and to the credit of the corporation. 4. Filing of the articles of incorporation together with the following: Treasurer’s affidavit Statement of assets and liabilities of the proposed corporation Authority to verify bank deposits Certificate of deposit of cash paid for subscription Personal information sheet of the incorporators Commitment to change corporate name if it is found similar to another corporate name 5. Payment of filing and publication fees 6. Issuance by SEC of the certificate of incorporation 7. Registration of the corporate name with DTI 8. Obtaining municipal licenses from LGU/CGU. 9. Obtaining the VAT or non-VAT account number from the BIR 10. Registration with BIR of books of accounts and accountable forms CONTENTS OF THE ARTICLES OF INCORPORATION Section 14 of the Corporation Codes states: All corporations organized under this Code shall file with the SEC articles of incorporation in any of the official languages duly signed and acknowledged by all of the incorporators, containing substantially the following matters, except as otherwise prescribed by this Code or by special law: 1. The names of the corporation: 2. The specific purpose/s for which the corporation is being incorporated. Where a corporation has more than one stated purpose, the articles of incorporation shall state which is the primary purpose and which is/are the secondary purpose/s: Provided, that a non-stock corporation may not include a purpose which would change or contradict its nature as such; 3. The place where the principal office of the corporation is to be located, which must be within the Philippines; 4. The term for which the corporation is to exist; 5. The names, nationalities and residences of the incorporators; 6. The number of directors or trustees, which shall not be less than five (5) nor more than 15; 7. The names, nationalities and residences of the persons who shall act as directors or trustees until the first regular directors or trustees are duly elected and qualified in accordance with this Code; 8. If it be a stock corporation, the amount of its authorized capital stock in lawful money of the Philippines, the number of shares into which it is divided, and in case the shares are par value shares, the par value of each, the names, nationalities and residences of the original subscribers, and the amount subscribed and paid by each on his subscription, and if some or all of the shares are without par value, such fact must be stated; 9. If it be a non-stock corporation, the amount of its capital, the names, nationalities and residences of the contributors and the amount contributed by each; and 10. Such other matters as are not inconsistent with law and which the incorporators may deem necessary and convenient. The SEC shall not accept the articles of incorporators of any stock corporation unless accompanied by a sworn statement of the Treasurer elected by the subscribers showing that at least 25% of the authorized capital stock of the corporation has been subscribed, and at least 25% of the total subscription has been fully paid to him in actual cash and/or in property the fair valuation of which is equal to at least 25% of the said subscription, such paid-up capital being not less than 5,000.00. BY – LAWS By-laws may be defined as the rules of action for the internal government of a corporation and for the government of its officers and stockholders or members. All corporations formed under the Corporation Code of the Philippines are required to adopt a code of by-laws within one (1) month after receipt of its corporate charter from the SEC. By-laws shall be effective only upon issuance by the SEC of a certification that the by-laws are not inconsistent with the provisions of the Corporation Code. It may provide for the following: 1. The time, place and manner of calling and conducting regular or special meetings of the directors or trustees. 2. The time and manner of calling and conducting regular or special meetings of the stockholders or members. 3. The required quorum in meetings of stockholders or members and the manner of voting therein. 4. The form of proxies of stockholders and members and the manner of voting therein. 5. The qualification, duties and compensation of directors or trustees and officers. 6. The time for holding the annual election of directors or trustees and the mode or manner of giving notice thereof.  7. The manner of election or appointment and the term of office of all officers other than directors or trustees. 8. In the case of stock corporations, the manner of issuing certificates. 9. The penalties for violation of the by-laws. 10. Other matters that may be necessary for the power and convenient transaction of its corporate business and affairs. SEC EXPRESS REGISTRATION SERVICES The SEC provides express incorporation services whereby for a fee, an applicant is given a standard set of incorporation papers to be filled up. RIGHTS OF STOCKHOLDERS Stockholders as owners of a corporation, have certain rights expressly recognized by the corporation law. These may be summarized as follows: 1. Right to attend and vote in person or by proxy at stockholders’ meeting (Sec. 50); 2. Right to receive dividend when declared (Sec. 43); 3. Right to inspect corporate books and records and to receive financial report of the corporation’s operations (Secs. 74-75); 4. Right to pre-emption in the issue of shares (Sec. 39); 5. Right to elect and remove directors (Secs. 24, 28); 6. Right to approve certain corporate acts (Secs. 49-54); 7. Right to issuance of certificate of stock or other evidence of stock ownership and be registered as shareholder (Sec. 63); 8. Right to transfer of stock on the corporate books (Sec. 63); 9. Right to participate in the distribution of corporate assets upon dissolution (Secs. 118-119). 10. Right to adopt and amend or repeal the by-laws or adopt new by-laws (Secs. 46-48); 11. Right to compel the calling of meeting of stockholders when for any because there is no person authorized to call a meeting (Sec. 50); 12. Right to enter into a voting trust agreement (Sec. 59); 13. Right to recover stock unlawfully sold for delinquency (Sec. 69); 14. Right to bring individual and representative or derivative suits; 15. Right to demand payment of the value of his shares and withdraw from the corporation in certain cases (Sec. 41 and 81); 16. Right to have the corporation voluntarily dissolved (Secs. 118-119). PRE-EMPTIVE RIGHTS OF STOCKHOLDERS The pre-emptive rights of a stockholder refer to his right to subscribe to all issues or disposition of shares of any class, in proportion to his shareholdings subject to certain exception per Sec. 39 of the Corporation Code. This right aims to safeguard stockholders against unfairness in the issue of shares to manipulate voting power of some stockholders and dilute the value of their proportionate interest. Example: J. Malaluan owns 5,000 shares of the 25,000 outstanding shares of capital stock of AB Manufacturing Corp. The firm is issuing additional 15,000 shares to raise additional capital. If J. Malaluan is not allowed to subscribe to the new issue in proportion to his shareholdings, his proportionate interest would go down from 20% to 12.5% Proportionate interest at present: 5,000 shares owned / 25,000 shares outstanding = 20% Proportionate interest at present: 5,000 shares owned / 40,000 shares outstanding = 12.5% The adverse effect on the proportionate interest of A. Robledo will be compounded if the additional shares were to be issued at a price lower than the current book value per share. Assume that the current book value per share is 150.00 and the new issue is to be issued to other stockholders at par value of 100.00. The current book of J. Malaluan’s shareholdings of 750,000.00 would go down to 656,250.00 or book value per share would go down from 150.00 to 131.25. The computations are as follows: Total stockholders’ equity at present: (25,000 shares outstanding x 150 book value per share) 3,750,000 Add: New issue of 15,000 shares at 100 1,500,000 Total stockholders’ equity after new issue 5,250,000 Divide by 40,000 shares outstanding 40,000 shares Book value per share after new issue 131.25 Book value of A. Robledo’ shareholdings (5,000 x 131.25) 656,250 Decrease in book value of A. Robledo’s shareholdi ngs (5,000 shares at 150 = 750,000 – 656,250) 93,750 VOTING IN A STOCK CORPORATION The manner of voting in a stock corporation is called cumulative voting. A stockholder is entitled to cast votes equal to the number of shares he owns multiplied by the number of directors or trustees to be elected. He may cast the said number of votes for only one candidate or divide the same among the candidates he chooses. Example: A. Robledo owns 7,000 shares of the 25,000 outstanding shares of the capital stock of XY Corporation. There are seven seats in the BOD (board of directors). He can cast a total of 49,000 votes (7,000 x 7 seats). He may divide this total among the number of candidates he wishes to vote for. Should he decide to vote for three (3) candidates, he may divide the 49,000 votes in any manner he wants among the chosen three. In case he decides to vote for only one candidate, he may cast the total of 49,000 for the candidate of his choice. Number of Shares to Ensure Election to the Board of Directors. Oftentimes, a stockholder would want to be represented or voted to the BOD. To ensure his election to the board, he must have sufficient number of votes based on shares owned and proxies obtained from other stockholders. The formula used in determining the number of shares he must represent is as follows: No. of shares to ensure Total no. of shares outstanding (S) x desired no. of seats (D) = +1 election (N) Total no. of directors to be elected (T) + 1 Example: J. Malaluan would want to have 3 seats in the BOD of XYZ Corporation which has 120,000 shares of capital stock outstanding and 11 directors. The three seats in the BOD, the number of shares that J. Malaluan must have or represent, is computed as follows: No. of shares to ensure 120,000 x 3 = +1 election (N) 11 + 1 = 30,001 shares The number of shares may also be derived at as follows: D 3 N= [ xS ]+1 = [ x 120,000 ]+1 = 30,001 shares T+1 11 + 1 In a reverse case, the number of seats that a given number of shares can get is computed as follows: No. of seat = Number of No. of directors to be elected + 1 shares held – 1 x Total number of shares outstanding  11 + 1 = 30,001 – 1 x = 3 seats 120,000 VOTING IN A NON- STOCK CORPORATION Every member of a non-stock corporation may cast as many votes as there are trustees to be elected but may not cast more than one vote for one candidate unless cumulative voting is authorized in the article of incorporation. Example: J. Malaluan is a member of a professional organization in which ten (10) trustees are to be elected. He may cast only one (1) vote for each of the candidates he chooses. If the articles of incorporation authorize the practice of cumulative voting, he may cast ten (10) votes for one candidate or divide them between some of the candidates. CLASSES OF SHARES OF STOCK The shares of stock which a corporation can issue may be classified depending on voting power, preferences, rights and restrictions as may be provided for in the articles of incorporation. They may be grouped into: 1. Common stock and Preferred Stock Common stock represents the basic issue of shares and has all the basic rights of a share of stock so that it is often referred to as the basic ownership in a corporation. Common stockholders have the same rights and privileges or they have no preferences over one another, thus, the term common. Preferred stock is a class of stock having preferences over common stock. These preferences may be in distribution of dividends and/or corporate assets upon dissolution of the corporation. 2. Class “A” and Class “B” Shares Stocks have been classified as Class A and Class B to keep track of Filipino and foreign ownership in a corporation. Class A shares are for Filipino shareholders and Class B shares are for foreign investors. Philippine citizens, however, are not prohibited from acquiring Class B shares. 3. Par Value and Non-Par Value Shares Par value shares refers to shares of capital stock that have been assigned a definite fixed value in the articles of incorporation so as to fix the minimum subscription or original issue price thereof. No-par value shares are those that have not been assigned a definite or fixed value. They may be assigned a stated value to serve as the minimum issue price. 4. Founders’ Shares Founders’ shares are those classified as such in the articles of incorporation and may be given certain rights and privileges not enjoyed by other stockholders. CORPORATE OFFICERS A corporation must have a president (who shall be a director), a treasurer (who may or may not be a director) a secretary (who shall be a resident and citizen of the Philippines) and such other officers as may be held concurrently by the same person, except that no one shall act as president and secretary or as president and treasurer at the same time. DISTINCTIONS BETWEEN A CORPORATION AND A PARTNERSHIP The distinctions between a corporation and a partnership may be summarized as follows: Corporation Partnership Governing Laws Corporation Code Civil Code Manner of Creation It is created by law or operation of law. It can be created by a mere agreement of the parties.  Number of Incorporators At least five (5) incorporators are required. It may be organized by only two (2) persons. Commencement of juridical personality It begins to have corporate existence and juridical It commences to acquire juridical personality personality only from the date of issuance of the from the moment of the execution of the contract certificate of incorporation by SEC under its of partnership. official seal. Powers It can exercise only the powers expressly granted It may exercise any power authorized by the by law or implied from those granted or incident partners provided it is not contrary to law, to its existence. morals, good customs, public order or public policy. Management The power to do business and manage its affairs When management is not agreed upon, every is vested in the BOD or trustees. partner is an agent of the partnership. Right of succession It has the right of succession. It has no right of succession. Terms of existence It may be formed for a term not longer than 50 It may be established for any period of time as years subject to extension to not more than 50 stipulated by the partners. years in any one instance. Firm name It may adopt any firm name provided it is not In the case of a limited partnership, it is required identical or deceptively similar to any registered by law to add the word Limited (Ltd.) to its name. firm name, or contrary to existing laws. Transferability of interest A stockholder has the right to transfer his shares A partner cannot transfer his interest in the without the prior consent of the other partnership without the consent of all the other stockholders. existing partners. Extent of liability to third parties Stockholders have limited liability, that is, they Partners (except limited partners) have unlimited are liable only to the extent of their liability. shareholdings. Effect of mismanagement The corporation as a juridical personality, can sue Partner can sue a co-partner who mismanages. or file a suit against a member of the BOD or trustees who mismanages. Dissolution It can only dissolve with the consent of the State. It may be dissolved at any time by the will of any or all of the partners. SIMILARITIES BETWEEN A CORPORATION AND A PARTNERSHIP The similarities between a corporation and a partnership may be summarized as follows: a. Each of the item has a juridical personality separate and distinct from those of the individuals composing it; b. They can be organized only where there is a law authorizing their organization; c. They can act only through agents; d. They are composed of an aggregate of individuals; e. They distribute their profits to those who contribute capital (although in the case of a partnership, the industrial partner also shares in partnership profits); f. Both of them are subject to corporate income tax (except in the case of general professional partnerships). DIVIDENDS, CUM-DIVIDEND AND EX-DIVIDEND STOCKS Dividend, in general, refers to items of value received by stockholders from an investee corporation arising from the investor-investee relationship. All assets and earnings of a corporation are owned by the corporation and not by its stockholders. They may be transferred to stockholders upon declaration by the BOD. The BOD is authorized by the Corporation Code of the Philippines to declare dividends subject to approval by at least 2/3 of the outstanding capital stock. The date of record and date of payment are specified in the declaration. Date of record. This refers to the date as of which, stockholders who appear on record as such, are entitled to dividends. From the date of declaration to the date of record, stocks are called cum-dividend. After this date, they are called ex-dividend. Cum-dividend stocks command higher prices as compared to ex-dividend stocks. Cut-off date. In the absence of any other date given, the cut-off date must be announced record date. However, in the Philippines, although the date of record is set as of a given date, the cut-off date may be earlier (especially for stocks that are heavily traded in the stock market) for the stock and transfer office often requires a number of days for the recording process. Date of payment. This refers to the date the stockholders are paid the dividends. Example: On April 1, 1993, the BOD of Alpha Manufacturing Corp. declared a 10% cash dividend on its capital stock (par value – 100.00) to stockholders on records as of May 1, 1993 payable on June 5, 1993. The stock and transfer office requires 7 days as allowance for the updating of its records so that the real cut-off date has been set at April 24. In the given example, April 1st is the date of declaration, May 1st is the date of record, April 24th is the cut-off date and June 5th, the date of payment. From April 1 to April 23, 1992, the stock of the corporation is called cum-dividend. Thereafter, they are called ex-dividend. RESTRICTION TO RETENTION OF CORPORATE EARNINGS The Corporation Code of the Philippines (Sec. 43) states, among others, the following: Stock corporation are prohibited from retaining surplus profits in excess of 100% of their paid-in capital stock except: (1) when justified by definite corporate expansion projects or programs approved by the BOD; or (2) when the corporation is prohibited under any loan agreement with any financial institution or creditor, whether local or foreign, from declaring dividends without its/his consent, and such consent has not yet been secured; or (3) when it can be clearly shown that such retention is necessary under special circumstances obtaining in the corporation, such as when there is a need for special reserve for probable contingencies. The Bureau of Internal Revenue (BIR) penalized corporations that violated this specific provisions but refrained from doing so afterwards. At the time of this writing, it is the SEC that penalizes corporations violating this provision. CLASSIFICATION OF DIVIDENDS; EFFECTS ON CORPORATE ACCOUNTS Dividend may be classified as follows: 1. Cash dividend. This is paid in cash to the stockholders. Effects on corporate accounts: Decrease in retained earnings and decrease in cash. If an entry is made upon declaration, the immediate effects would be decrease in retained earnings and increase in current liability (dividend payable). 2. Property dividend. This is in the form of non-cash assets of a corporation. An example is DJ Corporation (which has invested in the stocks of MR Inc.) which distributes the stock of MR Inc. to its stockholders as dividend.  Effects on corporate accounts: Decrease in retained earnings and decrease in assets (investment). 3. Stock dividend. Dividend in the form of stock of the issuing corporation. Example DJ Corporation (which has 10,000 shares of its capital stock outstanding) distributes a 15% stock dividend. This means that it issues 1,500 shares of its own capital stock so that the total outstanding number of shares must become 11,500. Effects on corporate accounts: Decrease in retained earnings and increase in capital stock. If an entry is made upon declaration, the immediate effects would be decrease in retained earnings and increase in stockholders’ equity account (stock dividend distributable). 4. Scrip dividend. Dividend in the form of promissory notes indicating the kind of benefits the stockholders shall be entitled to receive in the future (cash, non-cash assets, stock or some other form of dividend). Effects on corporate accounts: Decrease in retained earnings and either increase in current liabilities, long-term liabilities, or stockholders’ equity, depending on the nature of benefits to be ultimately granted to stockholders. 5. Bond dividend. This is in the form of bonds of the company. Effects on corporate accounts: Decrease in retained earnings and increase in liabilities. 6. Liquidating dividend. This refers to return of capital by a corporation. In effect, it is a distribution of the assets of the corporation upon its dissolution or cessation of its operations. Effects on corporate accounts: Decrease in capital stock and premium on capital stock (or additional paid-in capital) and decrease in assets. ADVANTAGES AND DISADVANTAGES OF A CORPORATION A corporate form of organization, just like sole proprietorships and partnerships, also has its advantages and disadvantages. They may be summarized as follows: Advantages Disadvantages It has a legal capacity to as a legal unit. It is subject to greater degree of governmental control and supervision. It has continuity of existence. Its cost of formation and operation is relatively high. Management is centralized in the BOD or Its formation and management are relatively trustees. complicated. The creation, organization, management and It is subject to higher income tax rate. dissolution processes are standardized Corporate income tax of 35% whereas for because they are governed by one general individuals, the rates range from 1% to 35%. incorporation law. Shareholders have limited liability. It has limited powers. A corporation can do only what is expressly or impliedly allowed by law or by its articles of incorporation. Other acts may be considered ultra vires. Shareholders are not general agents of the It is possible for the BOD to abuse its powers corporation. inasmuch as directors are usually the majority stockholders. Shareholders can transfer their shareholdings without the consent of other shareholders. It has the ability to raise more capital. Its credit is strengthened by its continuous existence and it can issue additional shares of stocks to a greater number of people and to other corporations. Its ability to raise more capital makes feasible gigantic financial ventures. Stockholders are taxed only on their shares of distributed earnings.  CHAPTER III – FINANCIAL PLANNING; TOOLS AND CONCEPTS Learning Objectives: Define financial planning. Budgeting, budgetary control, financial leverage, master budget, capital, operational leverage, contribution margin, time value of money, contribution margin, margin of safety, common size statement financial ratios and other terms given in the chapter. Enumerate the following: Limitations of financial statements; Functions of a master budget and its components; Standards used in analyzing financial statements; Differences between invested and borrowed capital; Factors affecting gross profit and the formulae; Financial ratios and their definitions and how they are grouped. State the significance of: Breakeven chart and interpret its contents; Time value of money in evaluating capital investment proposals. Analyze financial statements using the different tools and techniques. FINANCIAL PLANNING: TOOLS AND TECHNIQUES Inasmuch as most business decisions affect the financial resources of a company, financial planning is part and parcel of corporate, strategic, operational and project planning in an enterprise. It requires knowledge of economics and proficiency in the use of tools and techniques in processing and interpreting financial data so that financial projections can be made based on the different options available to management. FINANCIAL, CORPORATE, STRATEGIC, PROJECT AND OPERATIONAL PLANNING DEFINED Financial planning refers to the process of determining the best uses of the financial resources of an organization to attain its predetermined objectives, and the procurement of the required funds at the least cost. Corporate planning has been defined as a formal and systematic managerial process organized by responsibility, time and information, to ensure that operational planning, project planning, and strategic planning are carried out regularly to enable top management to direct and control the future of the enterprise. Strategic planning is the process of making decisions which will tend to optimize the organization’s future position despite changes in the environment. A strategy is a plan, an integration of a n organization’s important objectives, policies and programs into a cohesive whole. It marshals and allocates the organization’s limited resources into a viable posture to best achieve its goals considering its weaknesses and strengths relative to expected opportunities and threats in the future environment. Project planning or capital expenditure planning refers to working out the detailed execution of an action outside the scope of current operations such as acquisition of another company, a new plant, a new market or adoption of a new system. Operational planning refers to forward planning of existing operations. It involves the determination of how to effectively use current resources to attain both short-range goals and long-range objectives. Long range plans are adopted based on which short-range plans are formulated and quantified in the budgeting process. THE FINANCIAL PLANNING PROCESS In planning the best uses of a firm’s resources, the different steps followed are based on the following questions: Where are we now? This requires analysis of the current financial statement of a company, namely, its balance sheet, income statement and cash flow statement. This is done to detect areas of strengths, and  weaknesses as indicated by the measures of liquidity or short term solvency, profitability and stability. How did we get there? 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, inability to plough back earnings by declaring the greater portion annual net income as dividends, and unprofitable operations of some sub-units. Where do we want to go? The different alternatives are evaluated and the best choice is made considering the projected outcomes. This requires financial projections such as estimates of cash flows, revenue, costs, and expenses and the resulting financial ratios. BUDGETING, ITS OBJECTIVES AND BUDGETARY CONTROL Budgeting is the process of translating a plan in a quantitative term, usually monetary. Once the major undertakings of an enterprise have been programmed, they are restated in quantitative terms in a formal statement called the budget. A budget, therefore, is a formal statement of a planned course of action expressed in quantitative terms. The objectives of budgeting are the following: Planning. The financial plans of the different sub-units are prepared geared towards the attainment of the company’s predetermined objectives. These include the profit plan, budgeted balance sheets, capital expenditures budget, and the cash budget so that expected results of operations and their effects on financial resources can be visualized. Coordination. Budgeting brings about harmony and synchronized operations for the different levels of management. Heads of the different sub-units of an organization are made aware of their common goals and their contributions to the attainment of company objectives. Control. Budgeting provides management with the yardstick in evaluating performance. Periodic comparison between actual and budget figures is done to ensure the operations are in accordance with plans and therefore geared towards predetermined objectives. Variances are analyzed and the possible cause are determined to minimize if not totally avoid them for the rest of the year. Budgetary Control refers to the use of budgets and budgetary reports to coordinate, evaluate and control day-to-day operations to attain the goals specified by 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. As such, it serves as the management’s principal vehicle for coordinating the plans of the firm. It consists of the following: 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. 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. Capital expenditures budget. This is in the form of a statement showing the planned procurement and disposal of plant, property and equipment. THE BUDGETING PROCESS Top management formulates its overall objectives, plans and policies and assumptions to serve as guidelines in the preparation of the budget estimates. The preparation of budget estimates starts with sales forecasting so that sales forecast is considered the cornerstone in budgeting. The sales budget is then prepared based on sales forecasts depending on the level of operations at which management would want to operate. The planned or budgeted sales volume serve as the basis in determining production/purchase volume and costs and expenses involved. The head of the different responsibility centers, in consultation with their immediate supervisors, prepare their individual budgets based on the planned volume of activities. The individual budgets are then consolidated into a tentative master budget which may undergo revisions until an acceptable one is produced. Top management approves the final master budget and disseminates the approved budget to the different responsibility centers. TIME PERIODS IN CASH PLANNING AND CONTROL Cash planning and control may be classified based on time periods involved as operational, short-term, and long-term. Cash planning and control is classified as operational when it is undertaken for a period in the immediate future, say, a month, week or day, to be more precise in controlling cash balances. It is considered short- term when it is concerned with anticipating and providing for short – term credit needs and cash control for the coming year and is synchronized with the annual budget. Long – term cash planning and control extends beyond the coming year for it is concerned with major outflows and inflows and is synchronized with the time dimensions of long-range corporate plans and capital investment projects. CASH BUDGET AND CASH FORECAST As stated earlier, a cash budget is part of the master budget so that it is a coordinated plan of cash flows and resulting interim and final cash balances based on a program of operations over a specified budget period. On the other hand, a cash forecast is merely a projection of anticipated receipts and disbursements within a specified and the resulting cash balance. 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. The more useful form would be one showing cash provided by operations, required minimum cash balance, estimated cash deficiency (or excess). This form would be much more than a component of the master budget and its usefulness lies in its ability to forewarn managers of a possible cash deficiency or inform them in advance of excess funds so that appropriate decisions may be made. An example of cash budget is the following: J&DA Corporation Cash Budget For 2010 QUARTER For the year First Second Third Fourth Cash from operations: Estimated collection on sales: Sales on account 8,000 7,000 9,000 6,500 30,500 Cash sales 2,500 3,000 5,000 4,000 14,500 TOTAL 10,500 10,000 14,000 10,500 45,000 Estimated disbursements: Purchases 8,500 8,000 6,000 3,000 25,500 Operating expenses 5,000 3,500 2,700 1,600 12,800 TOTAL 13,500 11,500 8,700 4,600 38,300 Net cash flow from operations (3,000) (1,500) 5,300 5,900 6,700 Partial payment on equipment (6,500) (2,500) (2,500) (11,500) Interest expense on existing loans (800) (800) (700) (600) (2,900)  Net cash inflows prior to (10,300) (2,300) 2,100 2,800 (7,700) additional financing Cash balance beginning 2,000 3,900 3,600 4,700 2,000 Required ending balance (3,000) (2,500) (2,000) (1,800) (1,800) Cash excess (deficiency) (11,300) (900) 3,700 5,700 (7,500) Loans to be obtained 13,000 3,000 16,000 Interest expense on loans to be (800) (1,000) (1,000) (1,000) (3,800) obtained Cash balance in excess of required 900 1,100 2,700 4,700 4,700 ending balance Cash balance, end 3,900 3,600 4,700 6,500 6,500 CONCEPTS OF CAPITAL The term capital has been used in different concepts depending on from whose point of view it is being referred to. From the point of view of a businessman who has just started his own business, capital would refer to the resources he has accumulated and invested in his venture. Afterwards, the term would refer to all the investments he has made in the business (initial and additional investments) plus all earnings he has accumulated therein. From the point of view of the business itself, capital refers to all the resources available for its use as an economic entity regardless of their sources. Thus, in a broad sense, the total capital of a business would refer to its total assets whether provided by creditors or by its owners. SOURCES OF CAPITAL The total capital of a business, as stated in the preceding paragraph, consists of borrowed and equity capital. 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. The amount of thereof is computed by subtracting total liabilities from total assets of a business. Increases in equity capital are affected by additional investments by the owner or owner and retention (or ploughing back) of earnings. For a corporation, additional investments by owners is effected by issuing additional shares of capital stock. The equity of owners in a business may be called owner’s equity (sole proprietorship), partners’ equity (partnership), or stockholders’ equity (corporation) and may be presented as follows: Sole Proprietorship Owner’s equity: J. Malaluan, Capital, January 1, 2021 30,000.00 Add: Net Income for 2021 12,500.00 42,500.00 Less: Drawings 7,000.00 J. Malaluan, Capital, December 31, 2021 35,000.00 Partnership Partners’ equity: A. Robledo 75,000.00 E. Hernandez 45,000.00 E. Catapang 55,000.00 Total partners’ equity 175,000.00 Corporation: Stockholders’ equity Contributed capital 12% preferred stock, non-participating  Authorized 20,000 shares, par value 100 Issued 18,000 shares of which 200 shares are in treasury 1,800,000.00 Common stock Authorized 40,000 shares, par value 50 Issued 30,000 shares 1,500,000.00 Additional Contributed Capital Premium on preferred stock 200,000.00 Premium on common stock 300,000.00 Total contributed capital 3,800,000.00 Retained earnings Appropriate for: Plant expansion 1,500,000.00 Cost of treasury stock 19,000.00 Total appropriated 1,519,000.00 Unappropriated 2,000,000.00 3,519,000.00 Total 7,319,000.00 Less: Cost of treasury stock - Common 19,000.00 Total stockholders’ equity 7,300,000.00 Increases in equity capital are effected by additional investments by the owner/s and retention (or ploughing back) of earnings. For a corporation, additional investment by owners is effected by issuing additional shares of capital stock. Effects of dividends on equity capital. Dividends, with the exception of liquidating dividends, are distribution of corporate earnings. As enumerated and defined in Chapter II, not all dividends reduce equity capital. The effects are summarized as follows: EFFECTS ON Other accounts affected Equity capital Retained earnings a. Cash dividends Decrease Decrease Cash - Decrease b. Property dividends Decrease Decrease Assets - Decrease c. Stock dividends No effect Decrease Capital Stock - Increase d. Scrip dividends Decrease Decrease Liabilities - Increase e. Bond dividends Decrease Decrease Liabilities - Increase f. Liquidating dividends Decrease - Capital stock – Decrease Assets - Decrease Based on the foregoing enumeration, it may be noted that in the case of stock dividends, the total equity capital is not affected for it is merely a transfer from retained earnings to capital stock. Retention or Ploughing Back of Earnings. It has been emphasized earlier in this section that one way of increasing equity capital is by retaining earning in the business. This is effected as follows: The owner withdraws only a portion of his business earnings so that the Sole Proprietorship earnings not withdrawn are added to his capital account. Although partnership net income is distributed by credits to partners’ personal or drawing accounts, actual withdrawals are limited to only a Partnership portion thereof so that the personal drawing accounts are left with credit balance. The BOD declares only a portion of retained earnings as dividends. In most cases, the board opts to declare stock dividends so as not to reduce Corporation the equity capital and avoid cash outlay or decrease in total financial resources. Although stock dividends, in general, do not affect cash or working capital, they may ultimately require more cash outlay for dividends if the corporation has adopted policy of declaring fixed amount of cash dividends per share. To avoid such an increase in cash outlay, the cash dividends per share may be reduced in proportion to the increase in the number of outstanding shares of capital stock. Example: DJ Corporation had 1,000,000 shares of common stock outstanding as of December 31, 2019 and has adopted the policy of paying annual cash dividends of P.08 per share. Its BOD declared stock dividends of 20% on January 1, 2020 and 30% as of January 1, 2021. The number of outstanding shares and the corresponding cash dividends would be as follows: Number of shares Cash dividends Outstanding, December 31, 2019 1,000,000 20% stock dividend, January 1, 2020 (1,000,000 shares x 20%) 200,000 Outstanding, 2020 1,200,000 Cash dividends, 2021 (P.08 x 1,200,000 shares) 96,000 30% stock dividend, January 1, 2021 (1,200,000 shares x 30%) 360,000 Outstanding, 2021 1,560,000 Cash dividends, 2021 (P.08 x 1,560,000 shares) 124,800 From the foregoing example, it may be noted that cash requirement for cash dividends increased from 96,000 by 28,800. Should the corporation desire to maintain the annual cash dividends at level not exceeding 96,000, it has to reduce the cash dividend rate per share from.08 to.0615 (96,000/1,560,000 shares) or lower. BORROWED CAPITAL Capital acquired that gives rise to a liability (or debtor-creditor relationship) is borrowed capital. Increases in liabilities are effected in a number of ways and some of them are as follows: Purchasing goods, property and equipment and availing of other parties’ services on account or charge basis; Obtaining loans from financing companies; Receiving advances from offices and affiliate companies; Issuing commercial papers; Discounting notes receivable (or promissory notes received from customers and other third parties); Floating bonds. When a business firm acquires goods or avail of other parties’ service on charge basis, it is able to operate with smaller amount of equity capital especially when the short – term liability arising therefrom is due or payable after the expected collection from sale of the goods so purchased (in other words, collection period is longer than payment period). In periodic financial reports, liabilities are generally classified into current and long – term. Current liabilities are those maturing within one year. Liabilities that will mature beyond one year are classified as long – term debt. In financial circles, loans are classified based on their terms into short- term, medium and long – term. Short – term loans are those maturing within one year, medium (or intermediate) loans are those maturing after one year up to within five years; and long-term loans are those maturing beyond five years (up to 10, 20 or more years). Making use of borrowed capital is an example of financial leverage. The business is willing to pay interest and other charges on borrowed capital with the intention of raising the earnings per share on common stock. Financial leverage. The term leverage has been defined by Webster as “the mechanical advantage of power gained by using a lever”. Lever, in turn, is defined as a “bar or rigid piece, rotating about a fix axis or fulcrum, which lifts or sustains weight at one point by means of applied force at a second point”. Financial leverage, therefore, refers to the financial advantage derived from having additional funds considering the cost involved. The financial advantage from having additional funds may be expressed in terms of increased capacity to produce and sell, to create other sources of income and to take advantage of business opportunities are they arise, and the increase ability to offset or meet possible losses or downtrend in economic activities. Cost of Borrowed Capital. Interest is paid on borrowed capital. Inasmuch as it is deducted for income tax purposes, the corresponding tax benefit is treated as adjustment to interest expense in computing for the cost of borrowed capital. This cost is therefore computed as follows: Cost of borrowed capital = Interest x (1 – tax rate) Example: A. Robledo Corporation obtained a 20%, 200,000, one-year loan from J Malaluan Financing Company. Income tax rate is 35%. The cost of capital from this source is computed as follows: Cost of borrowed capital = 20% x (1 – 35%) = 13% Proof: Interest of 20% on 200,000 40,000.00 Tax benefit (35% of 40,000) 14,000.00 Interest expense net of tax benefit 26,000.00 Percentage (26,000/200,000) 13% INVESTED CAPITAL vs. BORROWED CAPITAL In determining whether a business entity should have more of invested capital or borrowed capital, the following differences should be considered: Invested capital is relatively permanent for it stays with the business until it is gradually reduced by accumulated losses or until the business is dissolved. Borrowed capital has its maturity date or requires periodic amortizations so that the cash budgets should provide for these periodic outlays. Dividends are paid on invested capital while financing charges are paid on borrowed capital. Dividends are not deductible for income tax purposes while financing charges (interest expense and service charges) are deductible so that the latter give rise to tax benefits while the former do not. In managing the capital of a business, management tries to maximize earnings on invested capital and minimize financing charges on borrowed capital. Upon the dissolution of a business entity, invested capital is returned to owners after the claims of third parties have been fully paid. In other words, creditors’ claims have priority over owners in asset distribution in the liquidation process. When the rate of return that can be realized from the use of borrowed capital is higher than its cost, the use of borrowed capital, to a certain extent, is advisable. Example: A. Robledo Corporation is planning to undertake a certain project that will require investment of 200,000 from which it expects to realize a 25% rate of return. Loans may be obtained at the interest rate of 18% per annum. Income tax rate is 35%. Cost of borrowed capital = 18% (1 – 35%) = 11.7% Making use of borrowed capital in the proposed project would therefore result in an incremental income of 13.3% (that is, 25% rate of return from the project minus 11.7% cost of borrowed capital). If ABC Corporation is currently realizing a net income of 30,000 on invested capital of 100,000 (divided into 10,000 shares of capital stock with par value of 10.00 each), the additional income from the project would raise the rate of return on owners’ equity from 30% to 56.6% and the earnings per share (EPS) from 3.00 to 5.66, computed as follows: At Present From Proposed Project Total Net income 30,000 (200,000 x 13.3%) = 26,600 56,600 Owner’s equity 100,000 100,000 Rate of return on owners’ equity 30% 56.6% Earnings per share (EPS) 30,000 / 10,000 shares 3.00 56,600 / 10,000 shares 5.66 In the foregoing illustration, the owners’ equity remains at 100,000 despite the additional resources made available for its use because they come from creditors. The additional resources generate additional income thereby raising the rate of return on owners’ equity and the earnings per share. They also raise the debt/equity ratio from 0:1 to 2:1 computed as follows: At Present Per Proposal Total Total liabilities 0 200,000 200,000 Owners’ equity 100,000 - 100,000 Debt/equity ratio 0:1 2:1 Making use of borrowed capital should be considered advisable only to the extent that it will not endanger the financial stability of a company. Aside from the financing charges to be met, the periodic maturity of the principal has to be provided for in cash budgets. FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES Analysis, as defined by Webster, is “a consideration of anything in its separate parts and their relation to each other”. The relationships arrived at are interpreted by determining their significance. Financial analysis refers to examination of financial data of an entity to determine its profitability, growth, solvency, stability and effectiveness of its management. Relationships between financial data are interpreted and their significances are use as guide in decision making process. Different tools and techniques are used in financial analysis depending on whether it is undertaken for short – term or for long – term decision making. The methods used for short – term decisions do not consider the time value of money; for long – term decisions, the time value of money of money is considered. They are as follows: For Short – Term Decision Making: a. Analysis of financial statements Horizontal analysis: Two or more sets of financial statements are used: Comparative statements Trend ratios Gross profit variation analysis Analysis of change in net income Vertical analysis: Only one set of financial statements is used: Common size statement Financial ratios b. Working capital and cash flow analysis c. Cost-volume profit (or breakeven point) analysis For Long – term Decision Making a. Payback Period b. Discount cash flow (DCF) methods: Internal rate of return Discounted payback period Net present value Profitability index It may be noted that the cash flow statement has been omitted from the foregoing list because it is now one of the statements required annually. This chapter delves on the methods used for short – term decision problems. The methods used for long – term decisions are taken up in Chapter VI. LIMITATIONS OF FINANCIAL STATEMENTS In analyzing financial statements, it is imperative for the users to bear in mind the limitations of financial statements so that the decisions may not be made based solely on the statements. These limitations are the following: 1. Variations in application of accounting principles. Although financial statements are prepared in accordance with generally accepted accounting principles, the application of these principles vary because of the different methods that may be used in income measurement and in determining the financial condition of a business. One accountant may be using the first-in first-out method of costing while another may be using last-in, first-out. Bad debts may be computed based on credit sales or on an aging of accounts. Depreciation may be computed based on production volume instead of using the straight-line method. 2. Financial statements are interim in nature although they give an impression of being accurate. The statements are prepared only for an accounting period and not for the entire life of a business entity. As such, they contain estimates of the results of operations and financial condition of the business. 3. Financial statements do not reflect changes in the purchasing power of the monetary unit. Financial statements are generally based on historical cost so that the current market values of assets are not reflected therein and the owners’ equity is merely the residual value after deducting total liabilities. This is due to the fact that accounting is primarily a steward function whereby the resources invested in the business are controlled and accounted for to protect the interests of both the creditors and the owners. 4. Financial statements do not contain all the significant facts about a business. They are prepared based in recorded transactions only so that other relevant information such as the quality of organization, location, and quality of and demand for its products are not included therein. STANDARDS IN FINANCIAL STATEMENT ANALYSIS In analyzing and interpreting financial statements of a particular entity, the analyst must somehow have standards with which he may compare the contents of said statements. These standards may be the figures, ratios, or percentages, or changes indicated in budgets, industry averages, competitors’ financial statements, and the company’s own financial statements for prior periods. COMPARATIVE STATEMENTS Comparative statements show the increases or decreases in account balances and their corresponding percentages. The following is an illustration thereof:  J Malaluan Corporation Comparative Income Statements For the Years Ended December 31, 2020 and 2019 2020 2019 Increase Amount (Decrease) % Sales 480,000 320,000 160,000 50% Less: Cost of Sales 200,000 160,000 40,000 25 Gross profit on sales 280,000 160,000 120,000 75 Less: Operating expenses Selling expenses 124,950 127,500 (2,550) 2 General and administrative expenses 45,000 40,000 5,000 12.5 Total operating expenses 169,950 167,500 2,450 1.5 Operating income 110,050 (7,500) 117,550 Less: Provision for income taxes 39,000 -- 39,000 Net income 71,050 (7,500) 78,550 In the foregoing comparative statements, the earlier date (2019) is considered as the base year so that the percentage of increase or decrease is arrived at by dividing the peso change by the 2019 figure. Thus, the percentage of change in sales of 50% is arrived at by dividing the 160,000 increase by the 2019 sales of 320,000. The percentage of change is also shown because changes in peso amounts only would be misleading. In the given example, it would be more meaningful to state that sales increased by 50% or by 160,000 rather than merely stating that sales increased by 160,000. TREND RATIOS Comparative statements are often supplemented by trend ratios or percentages showing the behavior of financial data for successive periods. The following income statements are used in preparing the sche