Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects.
The term "finance" may thus incorporate any of the following:
- The study of money and other assets;
- The management and control of those assets;
- Profiling and managing project risks;
- The science of managing money;
- As a verb, "to finance" is to provide funds for business or for an individual's large purchases (car, home, etc.).
The activity of finance is the application of a set of techniques that individuals and organizations (entities) use to manage their money, particularly the differences between income and expenditure and the risks of their investments.
An income that exceeds its expenditure can lend or invest the excess income. On the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income. The lender can find a borrower, a financial intermediary, such as a bank or buy notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary pockets the difference.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays the interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate their activity. Banks are thus compensators of money flows in space.
A specific example of corporate finance is the sale of stock by a company to institutional investors like investment banks, who in turn generally sell it to the public. The stock gives whoever owns it part ownership in that company. If you buy one share of XYZ Inc, and they have 100 shares outstanding (held by investors), you are 1/100 owner of that company. Of course, in return for the stock, the company receives cash, which it uses to expand its business in a process called "equity financing". Equity financing mixed with the sale of bonds (or any other debt financing) is called the company's capital structure.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance), etc., as well as by a wide variety of organizations including schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments, with consideration to their institutional setting.
Finance is one of the most important aspects of business management. Without proper financial planning a new enterprise is unlikely to be successful. Managing money (a liquid asset) is essential to ensure a secure future, both for the individual and an organization.
Personal Finance
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Questions in personal finance revolve around
- How much money will be needed by an individual (or by a family) at various points in the future?
- Where will this money come from (e.g. savings or borrowing)?
- How can people protect themselves against unforeseen events in their lives, and risk in financial markets?
- How can family assets be best transferred across generations (bequests and inheritance)?
- How do taxes (tax subsidies or penalties) affect personal financial decisions?
Personal financial decisions may involve paying for education, financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal financial decisions may also involve paying for a loan
Business Finance
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In the case of a company, managerial or corporate finance is the task of providing the funds for the corporation's activities. For small business, this is referred to as SME finance. It generally involves balancing risk and profitability.
Long term funds would be provided by ownership equity and long-term credit, often in the form of bonds. These decisions lead to the company's capital structure. Short-term funding or working capital is mostly provided by banks extending a line of credit.
On the bond market, borrowers package their debt in the form of bonds. The borrower receives the money that it borrows by selling the bond, which includes a promise to repay the value of the bond with interest. The purchaser of a bond can resell it so that the actual recipient of the interest payments can change over time. Bonds allow lenders to recoup the value of their loan by simply selling the bond.
Another business decision concerning finance is investment, or fund management. An investment is an acquisition of an asset in the hope that it will maintain or increase its value. In investment management -- in choosing a portfolio -- one has to decide what, how much and when to invest. In doing so, one needs to...
- Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion and tax considerations;
- Identify the appropriate strategy: active v. passive -- hedging strategy
- Measure the portfolio performance
Financial management is duplicate with the financial function of the Accounting profession. However, financial accounting is more concerned with the reporting of historical financial information, while the financial decision is directed toward the future of the firm.
Capital
Capital is the money which gives the business the power to buy goods to be used in the production of other goods or the offering of a service.
Sources of capital
Capital market
- Long-term funds are bought and sold:
- Shares
- Debentures
- Long-term loans, often with a mortgage bond as security
- Reserve funds
Money market
- Financial institutions can use short-term savings to lend out in the form of short-term loans:
- Credit on open account
- Bank overdraft
- Short-term loans
- Bills of exchange
- Factoring of debtors
Borrowed capital
This is capital which the business borrows from institutions or people, and includes debentures:
- Redeemable debentures
- Irredeemable debentures
- Debentures to bearer
Own capital
This is capital that owners of a business (shareholders and partners, for example) provide:
- Preference shares:
- Ordinary preference shares
- Cumulative preference shares
- Participating preference shares
- Ordinary shares
- Bonus shares
- Founders' shares
Differences between shares and debentures
- Shareholders are effectively owners; debenture-holders are creditors.
- Shareholders may vote at AGMs and be elected as directors; debenture-holders may not vote at AGMs or be elected as directors.
- Shareholders receive profit in the form of dividends; debenture-holders receive a fixed rate of interest.
- If there is no profit, the shareholder does not receive a dividend; interest is paid to debenture-holders regardless of whether or not a profit has been made.
Fixed capital
This is money which is used to purchase assets that will remain permanently in the business and help it to make a profit.
Factors determining fixed capital requirements
- Nature of business
- Size of business
- Stage of development
- Capital invested by the owners
Working capital
This is money which is used to buy stock, pay expenses and finance credit.
Factors determining working capital requirements
- Size of business
- Stage of development
- Time of production
- Rate of stock turnover
- Buying and selling terms
- Seasonal consumption
- Seasonal production
The desirability of budgeting
Capital budget
This concerns fixed asset requirements for the next five years and how these will be financed.
Cash budget
Working capital requirements of a business should be monitored at all times to ensure that there are sufficient funds available to meet short-term expenses.
Management of current assets
Credit policy
Credit gives the customer the opportunity to buy goods and services, and pay for them at a later date.
Advantages of credit trade
- Usually results in more customers than cash trade
- Can charge more for goods to cover the risk of bad debt
- Gain goodwill and loyalty of customers
- People can buy goods and pay for them at a later date.
- Farmers can buy seeds and implements, and pay for them only after the harvest.
- Stimulates agricultural and industrial production and commerce.
Disadvantages of credit trade
- Risk of bad debt
- High administration expenses
- People can buy more than they can afford.
- More working capital needed
Forms of credit
- Suppliers credit:
- Credit on ordinary open account
- Instalment sales
- Bills of exchange
- Credit cards
- Contractor's credit
- Factoring of debtors
Factors which influence credit conditions
- Nature of the business's activities
- Financial position
- Product durability
- Length of production process
- Competition and competitors' credit conditions
- Country's economic position
- Conditions at financial institutions
- Discount for early payment
- Debtor's type of business and financial position
Credit collection
Overdue accounts
- Cards arranged alphabetically in card index system
- Attach a notice of overdue account to statement.
- Send a letter asking for settlement of debt.
- Send a second or third letter if first is ineffectual.
- Threaten legal action.
Effective credit control
- Increases sales
- Reduces bad debts
- Increases profits
- Builds customer loyalty
Sources of information on creditworthiness
- Business references
- Bank references
- Credit agencies
- Chambers of commerce
- Employers
- Credit application forms
Duties of the credit department
- Legal action
- Taking necessary steps to ensure settlement of account
- Knowing the credit policy and procedures for credit control
- Setting credit limits
- Ensuring that statements of account are sent out
- Ensuring that thorough checks are carried out on credit customers
- Keeping records of all amounts owing
- Ensuring that debts are settled promptly
Stock
Purpose of stock control
- Ensures that enough stock is on hand to satisfy demand.
- Protects and monitors theft.
- Safeguards against having to stockpile.
- Allows for control over selling and cost price.
Stockpiling
This refers to the purchase of stock at the right time, at the right price and in the right quantities.
Advantages
- Losses due to price fluctuations and stock loss kept to a minimum
- Ensures that goods reach customers timeously; better service
- Saves space and storage cost
- Investment of working capital kept to minimum
- No loss in production due to delays
Disadvantages
- Obsolescence
- Danger of fire and theft
- Initial working capital investment is very large
- Losses due to price fluctuation
Influence of stock management on rate of return
- Right price
- Right quantity
- Right quality
- Right place
- Right time
- Right property
Rate of stock turnover
This refers to the number of times per year that the average level of stock is sold. It may be worked out by dividing the cost price of goods sold by the cost price of the average stock level.
Determining optimum stock levels
- Maximum stock level refers to the maximum stock level that may be maintained to ensure cost effectiveness.
- Minimum stock level refers to the point below which the stock level may not go.
- Standard order refers to the amount of stock generally ordered.
- Order level refers to the stock level which calls for an order to be made.
Cash
Reasons for keeping cash
- The transaction motive refers to the money kept available to pay expenses.
- The precautionary motive refers to the money kept aside for unforeseen expenses.
- The speculative motive refers the money kept aside to take advantage of suddenly arising opportunities.
Advantages of sufficient cash
- Current liabilities may be catered for.
- Cash discounts are given for cash payments.
- Production is kept moving.
- Surplus cash may be invested on a short-term basis.
- The business is able to pay its accounts timeously, allowing for easily-obtained credit.
Management of fixed assets
Depreciation
Depreciation is the decrease in the value of an asset due to wear and tear or obsolescence. It is calculated yearly to ensure realistic book values for assets.
Insurance
Insurance is the undertaking of one party to indemnify another, in exchange for a premium, against a certain eventuality.
Uninsurable risks
- Bad debt
- Changes in fashion
- Time lapses between ordering and delivery
- New machinery or technology
- Different prices at different places
Requirements of an insurance contract
- Insurable interest
- The insured must derive a real financial gain from that which he is insuring, or stand to lose if it is destroyed or lost.
- The item must belong to the insured.
- One person may take out insurance on the life of another if the second party owes the first money.
- Must be some person or item which can, legally, be insured.
- The insured must have a legal claim to that which he is insuring.
- Good faith
- Uberrimae fidei refers to absolute honesty and must characterise the dealings of both the insurer and the insured.
