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Finance

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Finance is the science of funds management.[1] The general areas of finance are business finance, personal finance, and public finance.[2] Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money and risk and how they are interrelated. It also deals with how money is spent and budgeted.

Finance works most basically through individuals and business organizations depositing money in a bank. The bank then lends the money out to other individuals or corporations for consumption or investment, and charges interest on the loans.

Loans have become increasingly packaged for resale, meaning that an investor buys the loan (debt) from a bank or directly from a corporation. Bonds are debt sold directly to investors from corporations, while that investor can then hold the debt and collect the interest or sell the debt on a secondary market. Banks are the main facilitators of funding through the provision of credit, although private equity, mutual funds, hedge funds, and other organizations have become important as they invest in various forms of debt. Financial assets, known as investments, are financially managed with careful attention to financial risk management to control financial risk. Financial instruments allow many forms of securitized assets to be traded on securities exchanges such as stock exchanges, including debt such as bonds as well as equity in publicly-traded corporations.[dubious – discuss]

Central banks act as lenders of last resort and control the money supply, which affects the interest rates charged. As money supply increases, interest rates decrease.[3]

The main techniques and sectors of the financial industry

Main article: Financial services

An entity whose income exceeds their 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; this process is known as "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), 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 and methodologies, 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

Main article: Personal finance

Questions in personal finance revolve around

  • How much money will be needed by an individual (or by a family), and when?
  • Where will this money come from, and how?
  • How can people protect themselves against unforeseen personal events, as well as those in the external economy?
  • How can family assets best be transferred across generations (bequests and inheritance)?
  • How does tax policy (tax subsidies or penalties) affect personal financial decisions?
  • How does credit affect an individual's financial standing?
  • How can one plan for a secure financial future in an environment of economic instability?

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, or debt obligations.

Corporate finance

Main article: Corporate finance

Managerial or corporate finance is the task of providing the funds for a corporation's activities. For small business, this is referred to as SME finance. It generally involves balancing risk and profitability, while attempting to maximize an entity's wealth and the value of its stock.

Long term funds are provided by ownership equity and long-term credit, often in the form of bonds. The balance between these forms the company's capital structure. Short-term funding or working capital is mostly provided by banks extending a line of credit.

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. To do this, a company must:

  • 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

Main article: Financial capital

Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the production of other goods or the offering of a service.

The desirability of budgeting

Budget is a document which documents the plan of the business. This may include the objective of business, targets set, and results in financial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve the planned sales, and financing source for the investment. Also budget may be long term or short term. Long term budgets have a time horizon of 5–10 years giving a vision to the company; short term is an annual budget which is drawn to control and operate in that particular year.

Capital budget

This concerns proposed fixed asset requirements and how these expenditures will be financed. Capital budgets are often adjusted annually and should be part of a longer-term Capital Improvements Plan.

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.

The cash budget is basically a detailed plan that shows all expected sources and uses of cash. The cash budget has the following six main sections:

  1. Beginning Cash Balance - contains the last period's closing cash balance.
  2. Cash collections - includes all expected cash receipts (all sources of cash for the period considered, mainly sales)
  3. Cash disbursements - lists all planned cash outflows for the period, excluding interest payments on short-term loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list (e.g. depreciation, amortisation, etc)
  4. Cash excess or deficiency - a function of the cash needs and cash available. Cash needs are determined by the total cash disbursements plus the minimum cash balance required by company policy. If total cash available is less than cash needs, a deficiency exists.
  5. Financing - discloses the planned borrowings and repayments, including interest.
  6. Ending Cash balance - simply reveals the planned ending cash balance.

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.
  • Can be used as a promotional tool.
  • Increase the sales.
  • Modest rates to be filled.
Disadvantages of credit trade
  • Risk of bad debt.
  • High administration expenses.
  • People can buy more than they can afford.
  • More working capital needed.
  • Risk of Bankruptcy.
  • May lose peace of mind.
Forms of credit
  • Suppliers credit:
  • Credit on ordinary open account
  • Installment sales
  • Bills of exchange
  • Credit cards
  • Contractor's credit
  • Factoring of debtors
  • Cash credit
  • Cpf credits
  • Exchange of product
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 positions
Credit collection
Overdue accounts
  • 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
  • Builds confidence of financial industry
  • increase company capitlisation
Sources of information on creditworthiness
  • Business references
  • Bank references
  • credit agencies
  • Chambers of commerce
  • Employers
  • Credit application forms
  • Credit repair companies
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
  • Timely reporting to the upper level of management for better management.

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
Main article: Cornering the market

This refers to the purchase of stock at the right time, at the right price and in the right quantities.

There are several advantages to the stockpiling, the following are some of the examples:

  • 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

There are several disadvantages to the stockpiling, the following are some of the examples:

  • Obsolescence
  • Danger of fire and theft
  • Initial working capital investment is very large
  • Losses due to price fluctuation
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
  • Cash is usually referred to as the "king" in finance, as it is the most liquid asset.
  • 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 to the money kept aside to take advantage of suddenly arising opportunities.
Advantages of sufficient cash
  • Current liabilties 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 in a timely manner, allowing for easily-obtained credit.
  • Liquidity

Management of fixed assets

Depreciation

Depreciation is the allocation of the cost of an asset over its useful life as determined at the time of purchase. It is calculated yearly to enforce the matching principle.

Insurance

Main article: Insurance

Insurance is the undertaking of one party to indemnify another, in exchange for a premium, against a certain eventuality.

Uninsured 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.

Shared Services

There is currently a move towards converging and consolidating Finance provisions into shared services within an organization. Rather than an organization having a number of separate Finance departments performing the same tasks from different locations a more centralized version can be created.

Finance of states

Main article: Public finance

Country, state, county, city or municipality finance is called public finance. It is concerned with

  • Identification of required expenditure of a public sector entity
  • Source(s) of that entity's revenue
  • The budgeting process
  • Debt issuance (municipal bonds) for public works projects

Financial economics

Main article: Financial economics

Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance.

It studies:

  • Valuation - Determination of the fair value of an asset
    • How risky is the asset? (identification of the asset appropriate discount rate)
    • What cash flows will it produce? (discounting of relevant cash flows)
    • How does the market price compare to similar assets? (relative valuation)
    • Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)

Financial Econometrics is the branch of Financial Economics that uses econometric techniques to parameterise the relationships.

Financial mathematics

Main article: Financial mathematics

Financial mathematics is a main branch of applied mathematics concerned with the financial markets. Financial mathematics is the study of financial data with the tools of mathematics, mainly statistics. Such data can be movements of securities—stocks and bonds etc.—and their relations. Another large subfield is insurance mathematics.

Experimental finance

Main article: Experimental finance

Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanisms, and returns processes. Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions, and attempt to discover new principles on which such theory can be extended. Research may proceed by conducting trading simulations or by establishing and studying the behaviour of people in artificial competitive market-like settings.

Behavioral finance

Main article: Behavioral finance

Behavioral Finance studies how the psychology of investors or managers affects financial decisions and markets. Behavioral finance has grown over the last few decades to become central to finance.

Behavioral finance includes such topics as:

  1. Empirical studies that demonstrate significant deviations from classical theories.
  2. Models of how psychology affects trading and prices
  3. Forecasting based on these methods.
  4. Studies of experimental asset markets and use of models to forecast experiments.

A strand of behavioral finance has been dubbed Quantitative Behavioral Finance, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has been lead by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran, Huseyin Merdan). Studies by Jeff Madura, Ray Sturm and others have demonstrated significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.

Intangible Asset Finance

Main article: Intangible asset finance

Intangible asset finance is the area of finance that deals with intangible assets such as patents, trademarks, goodwill, reputation, etc.

There are several related professional qualifications in finance, that can lead to the field:

See also

Main article: Outline of finance

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References

  1. ^ Gove, P. et al. 1961. Finance. Webster's Third New International Dictionary of the English Language Unabridged. Springfield, Massachusetts: G. & C. Merriam Company.
  2. ^ finance. (2009). In Encyclopædia Britannica. Retrieved June 23, 2009, from Encyclopædia Britannica Online: http://www.britannica.com/EBchecked/topic/207147/finance
  3. ^ Microsoft. 2009. Finance. uk.encarta.msn.com, http://www.webcitation.org/5hlUjB4mc
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