Module 02: Introduction to Financial Management - Financial Institutions

and Markets

I. LEARNING COMPETENCIES
1. Distinguish a financial institution from financial instrument and financial market.
2. Explain the flow of funds within an organization – through and from the
enterprise—and the role of the financial manager.
3. Prepare a diagram illustrating how the Financial System works.

II. LESSON PRESENTATION

Motivation
Let’s say you, a financial manager, and during your management of money, some cash
remains. What would you do with the cash?

Suppose you are going to save the money, where would you keep it?

Now here comes Pedro who has a business running and is profitable for some time. Pedro
then decides to expand his/her business but does not have enough cash to pay for the expansion.
Where can Pedro get additional funding?

Suppose Pedro knows that you have excess money and approached you to lend him/her
the capital he needs to expand his business for a 20% interest. Since you observe that Pedro's
business has been profitable, you are willing to lend Pedro the money since you are confident
that Pedro can repay his loan. You are now expecting to be 20% richer from your lending to
Pedro, and Pedro can now expand his operations to gain more profit for his business.
This scenario where the lender and the borrower are present at the right time and at the
right place may not happen all the time. In fact, it seldom happens. What happens if you and
Pedro don't meet? You will not be able to find someone to invest you money to and Pedro cannot
get funds to start his expansion. Here is where the Financial System comes in.
If you know that Pedro is in need of funds, or if Pedro knows that you are willing to
invest funds, you and Pedro may agree to make a Private Placement. See Image 1 below.
However, if these facts are unknown to them, you and Pedro can go to a Financial
Market which is an organized forum that lets you, along with other suppliers of funds, and
Pedro, along with other users of funds, meet and make transactions. Once you and Pedro have
met in the Financial Market, you both can now agree to make a private placement. See links in
Image 1.
If you and Pedro do not want to make an effort to find a counterparty in the Financial
Markets, you and Pedro may go to a Financial Institution. A Financial Institution will receive
your supply of funds and match it with Pedro’s demand of funds. Unlike the Financial Markets
were you and Pedro know to whom the fund went and from whom the funds came, Financial
Institutions serve as an intermediary to the suppliers and users of funds. See links in Image 1.
Moreover, Financial Institutions actively participate in the financial markets as both
suppliers and users of funds. See links in Image 1.
 The resulting diagram of all the links illustrates the Financial System.
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To Note: On the diagram presented, the solid lines represent the flow of cash/funds, while the broken lines
represent the flow of financial instruments which represent obligations to transfer cash or other assets in the
future.
How transactions between suppliers and users of funds take place? To prove that there
was a transaction and so that the demander will be able to repay the supplier on time and at the
right amount, transactions are made via Verbal Agreement and/or Written Agreement. Due to
the increased need for security for the performance of obligations arising from these transactions
and due to the growing size of the financial system, the transfers of funds from one party to
another are made through Financial Instruments.
Terms Defined:
Financial Markets - organized forums in which the suppliers and users of various types of funds
can make transactions directly.
Financial Institutions - intermediaries that channel the savings of individuals, businesses, and
governments into loans or investments.
Private Placements - the sale of a new security directly to an investor or group of investors.
Public Offering - the sale of either bonds or stocks to the general public.
Financial Instruments - is a real or a virtual document representing a legal agreement involving
some sort-of monetary value. These can be debt securities like corporate bonds or equity like
shares of stock.

Composition of the Financial System

In this module, we will further discuss the composition of the Financial System and that
we will identify the types of Financial Markets, Financial Institutions and Financial
Instruments.

I. Financial Instruments
When a financial instrument is issued, it gives rise to a financial asset on one hand and a
financial liability or equity instrument on the other.
Recall from FABM 1 the following definitions:
Financial Asset - is any asset that is:
a. Cash
b. An equity instrument of another entity
c. A contractual right to receive cash or another financial asset from another entity.
d. A contractual right to exchange instruments with another entity under conditions that
are potentially favorable. (IAS 32.11)
Examples: Notes Receivable, Loans Receivable, Investment in Stocks, Investment in
Bonds
Financial Liability - is any liability that is a contractual obligation:
a. To deliver cash or other financial instrument to another entity.
b. To exchange financial instruments with another entity under conditions that are
potentially unfavorable. (IAS 32)
Examples: Notes Payable, Loans Payable, Bonds Payable
Equity Instrument - is any contract that evidences a residual interest in the assets of an entity
after deducting all liabilities. (IAS 32)
Examples: Ordinary Share Capital, Preference Share Capital
The holders of Financial Assets are the Suppliers of Funds, while the makers of Financial
Liabilities and Equity instruments are the Users of Funds. When companies are in need of
funding, they either sell debt securities (or bonds) or issue equity instruments. The proceeds from
the sale of the debt securities and issuance of bonds will be used to finance the company’s plans.
On the other hand, investors buy debt securities of equity instruments in hopes of receiving
returns through interest, dividend income or appreciation in the financial asset’s price.

Common Examples of Debt and Equity Instruments

Debt Instruments - generally have fixed returns due to fixed interest rates. Examples of debt
instruments are as follows:
Treasury Bonds and Treasury Bills - are issued by the Philippine government. These
bonds and bills have usually low interest rates and have very low risk of default since the
government assures that these will be paid.
Corporate Bonds - are issued by publicly listed companies. These bonds usually have
higher interest rates than Treasury bonds. However, these bonds are not risk free. If the
company which issued the bonds goes bankrupt, the holder of the bonds will no longer
receive any return from their investment and even their principal investment can be
wiped out.
Equity Instruments - generally have varied returns based on the performance of the issuing
company. Returns from equity instruments come from either dividends or stock price
appreciation. The following are types of equity instruments:
Preferred Stock - has priority over a common stock in terms of claims over the assets of
a company. This means that if a company were to be liquidated and its assets have to be
distributed, no asset will be distributed to common stockholders unless all the claims of
the preferred stockholders have been given. Moreover, preferred stockholders have also
priority over common stockholders in cash dividend declaration. Dividends to preferred
stockholders are usually in a fixed rate. No cash dividends will be given to common
stockholders unless all the dividends due to preferred stockholders are paid first.
(Cayanan, 2015)
Common Stock - are the real owners of the company. If the company’s growth is
spurring, the common stockholders will benefit on the growth. Moreover, during a
profitable period for which a company may decide to declare higher dividends, preferred
stock will receive a fixed dividend rate while common stockholders receive all the
excess.
You will learn more about the advantages and disadvantages of debt and equity
instruments in the Module: Sources and Uses of Funds and Lesson 5: Introduction to
Investments.

II. Financial Markets

Recall the definition of financial markets from earlier discussion.
Classification of Financial Markets Into Comparative Groups
Primary vs. Secondary Markets
 To raise money, users of funds will go to a primary market to issue new securities
(either debt or equity) through a public offering or a private placement. The sale of new
securities to the general public is referred to as a public offering and the first offering of stock is
called an initial public offering. The sale of new securities to one investor or a group of
investors (institutional investors) is referred to as a private placement. However, suppliers of
funds or the holders of the securities may decide to sell the securities that have previously been
purchased. The sale of previously owned securities takes place in secondary markets. The
Philippine Stock Exchange (PSE) is both a primary and secondary market.
Money Markets vs. Capital Markets
Money Markets are a venue wherein securities with short-term maturities (1 year or
less) are sold. They are created because some individuals, businesses, governments, and financial
institutions have temporarily idle funds that they wish to invest in a relatively safe, interest-
bearing asset. At the same time, other individuals, businesses, governments, and financial
institutions find themselves in need of seasonal or temporary financing. On the other hand,
securities with longer-term maturities are sold in Capital Markets. The key capital market
securities are bonds (long-term debt) and both common stock and preferred stock (equity, or
ownership).

Terms Defined
Primary Market - Financial market in which securities are initially issued; the only market in
which the issuer is directly involved in the transaction.
Public Offering - The sale of either bonds or stocks to the general public.
Private Placement - The sale of a new security directly to an investor or group of investors.
Secondary Market - Financial market in which preowned securities (those that are not new
issues) are traded.
Money Market - A financial relationship created between suppliers and users of short-term
funds.
Capital Market - A market that enables suppliers and users of long-term funds to make
transactions.

III. Financial Institutions

Recall the definition of Financial Institutions from the earlier discussion.
Common Financial Institutions
Commercial Banks - Individuals deposit funds at commercial banks, which use the deposited
funds to provide commercial loans to firms and personal loans to individuals, and purchase debt
securities issued by firms or government agencies.
Insurance Companies - Individuals purchase insurance (life, property and casualty, and health)
protection with insurance premiums. The insurance companies pool these payments and invest
the proceeds in various securities until the funds are needed to pay off claims by policyholders.
Because they often own large blocks of a firm’s stocks or bonds, they frequently attempt to
influence the management of the firm to improve the firm’s performance, and ultimately, the
performance of the securities they own.
Mutual Funds - Mutual funds are owned by investment companies which enable small investors
to enjoy the benefits of investing in a diversified portfolio of securities purchased on their behalf
by professional investment managers. When mutual funds use money from investors to invest in
newly issued debt or equity securities, they finance new investment by firms. Conversely, when
they invest in debt or equity securities already held by investors, they are transferring ownership
of the securities among investors.
Pension Funds - Financial institutions that receive payments from employees and invest the
proceeds on their behalf.
Other Financial Institutions - Include pension funds like Government Service Insurance
System (GSIS) and Social Security System (SSS), unit investment trust fund (UITF), investment
banks, and credit unions, among others.
The figure below illustrates how the key financial institutions serve as intermediaries for
suppliers and users of funds.
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Image 2.2. Sample Capital Structure (Source: DepEd Business Finance Teaching Guide)

III. SUMMARY OF LESSON

 Financial Markets are organized forums in which the suppliers and users of various types of
funds can make transactions directly.
 Financial Institutions are intermediaries that channel the savings of individuals, businesses,
and governments into loans or investments.
 Private Placements is the sale of a new security directly to an investor or group of investors.
 Public Offering is the sale of either bonds or stocks to the general public.
 Financial Instruments is a real or a virtual document representing a legal agreement involving
some sort-of monetary value. These can be debt securities like corporate bonds or equity like
shares of stock.
 Primary Market is the Financial Market in which securities are initially issued; the only
market in which the issuer is directly involved in the transaction.
 Public Offering is the sale of either bonds or stocks to the general public.
 Private Placement is the sale of a new security directly to an investor or group of investors.
 Secondary Market is the Financial market in which preowned securities (those that are not
new issues) are traded.
 Money Market is a financial relationship created between suppliers and users of short-term
funds.
 Capital Market is a market that enables suppliers and users of long-term funds to make
transactions.

IV. ENRICHMENT
Question for Reflection: How would you relate the role of financial managers, role of financial
markets and role of investors? Answer briefly. (15 pts.; 5 pts. each)
Role of Financial Managers Role of Financial Markets Role of Investors
V. EVALUATION
A. True/False
Direction: Write True if you agree to the statement. Otherwise, write False. (2 pts. each)
1. To achieve the goal of profit maximization for each alternative being considered, the
financial manager would select the one that is expected to result in the highest monetary
return.
2. Dividend payments change directly with changes in earnings per share.
3. The wealth of corporate owners is measured by the share price of the stock.
4. Financial markets are intermediaries that channel the savings of individuals,
businesses, and government into loans or investments.
5. The money market involves trading of securities with maturities of one year or less
while the capital market involves the buying and selling of securities with maturities of
more than one year.
6. Primary and secondary markets are markets for short-term and long-term securities,
respectively.
7. Preferred stock is a special form of stock having a fixed periodic dividend that must be
paid prior to payment of any interest to outstanding bonds.
8. Commercial banks obtain most of their funds from borrowing in the capital markets.
9. Credit unions are the largest type of financial intermediary handling individual savings.
10. Credit unions are the largest type of financial intermediary handling individual
savings.

B. Multiple Choice
Direction: Encircle the letter of the correct answer. (2 pts. each)
1. The ______ is created by a financial relationship between suppliers and users of short-term
funds.
A. financial market
B. money market
C. stock market
D. capital market
2. Firms that require funds from external sources can obtain them from _____.
A. financial markets.
B. private placement.
 C. financial institutions.
D. All of the above.
3. The major securities traded in the capital markets are ____.
A. stocks and bonds.
B. bonds and commercial paper.
C. commercial paper and Treasury bills.
D. Treasury bills and certificates of deposit.
4. The primary goal of the financial manager is _____.
A. minimizing risk.
B. maximizing profit.
C. maximizing wealth.
D. minimizing return.
5. A financial manager must choose between four alternative Assets: 1, 2, 3, and 4. Each asset
costs $35,000 and is expected to provide earnings over a three-year period as described below.
/
Based on the profit maximization goal, the financial manager would choose _____.
A. Asset 1.
B. Asset 2.
C. Asset 3.
D. Asset 4.
6. A ______ is one financial intermediary handling individual savings. It receives premium
payments that are placed in loans or investments to accumulate funds to cover future benefits.
A. life insurance company
B. commercial bank
C. savings bank
D. credit union
7. Which of the following is not a financial institution?
A. A pension fund
B. A newspaper publisher
C. A commercial bank
D. An insurance company
8. A ______ is a type of financial intermediary that pools savings of individuals and makes them
available to business and government users.
Funds are obtained through the sale of shares.
A. mutual fund
B. savings and loans
C. savings bank
D. credit union
9. Which of the following is not a service provided by financial institutions?
A. Buying the businesses of customers
B. Investing customers’ savings in stocks and bonds
C. Paying savers’ interest on deposited funds
D. Lending money to customers
10. The ______ is created by a financial relationship between suppliers and users of short-term
funds.
A. financial market
 B. money market
C. stock market
D. capital market

VII. RESOURCES
DepEd Business Finance Teaching Guide
investopedia.com