Finance

Published on Friday, December 1st 2006. Edited by Gas Geladdcup, Zuidlaren, Netherlands.

Finance

Financial Markets

Bond market Stock (Equities) Market Forex market Derivatives market Commodity market Money market Spot (cash) Market OTC market Real Estate market

Market Participants

Investors Speculators Institutional Investors

Corporate finance

Structured finance Capital budgeting Financial risk management Mergers and Acquisitions Accounting Financial Statements Auditing Credit rating agency

Personal finance

Credit and Debt Employment contract Retirement Financial planning

Public finance

Tax

Banks and Banking

Fractional-reserve banking Central Bank List of banks Deposits Loan Money supply

Financial regulation

Finance designations Accounting scandals

History of finance

Stock market bubble Recession Stock market crash

The field of finance refers to the concepts of time, money and risk and how they are interrelated. 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;
• The industry that delivers financial services
• As a verb, “to finance” is to provide funds for business or for an individual’s large purchases (car, home, etc.).

The main techniques and sectors of the financial industry

An entity whose income 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), 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

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?
• 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.

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

Capital, in the financial sense, 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.

Borrowed capital

This is capital which the business borrows from institutions or people, and includes debentures:

• Redeemable debentures
• Irredeemable debentures
• Debentures to bearer
• Hardcore debentures

Own capital

This is capital that owners of a business (shareholders and partners, for example) provide:

• Preference shares/hybrid source of finance

• Ordinary preference shares

• Cumulative preference shares

• Participating preference share

• Ordinary shares

• Bonus shares
• Founders' shares

They have preference over the equity shares.Means the Payment made to the shareholders is done by firstly paying to preference shareholder and than to the equity shareholders.

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.
• In case of dissolution of firms debenture holders are paid first as compared to shareholder.

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
• location of that area

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 ratio
• Buying and selling terms
• Seasonal consumption
• Seasonal production
• seasonal cost

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.
• Can be used as a promotional tool.
• Increase the sales.

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.

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
• 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

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

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 to 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.
• Liquidity

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.

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

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

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 markets and instruments

• Commodities – topics

• Stocks – topics
• Bonds – topics
• Money market instruments- topics

• Derivatives – topics

• Financial institutions and regulation

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

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

Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents' behaviour 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.

Quantitative behavioural finance

Quantitative Behavioral Finance is a new discipline that uses mathematical and statistical methodology to understand behavioural biases in conjunction with valuation. Some of this endeavor has been lead by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioural 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 behavioural effects in stocks and exchange traded funds.

The research can be grouped into the following areas: 1. Empirical studies that demonstrate significant deviations from classical theories. 2. Modeling using the concepts of behavioural effects together with the non-classical assumption of the finiteness of assets. 3. Forecasting based on these methods. 4. Studies of experimental asset markets and use of models to forecast experiments.

Intangible Asset Finance

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

Related Professional Qualifications

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

• Qualified accountant qualifications: Chartered Certified Accountant (ACCA, UK certification), Chartered Accountant (CA, certification in Commonwealth countries), Certified Public Accountant (CPA, US certification)
• Non-statutory accountancy qualifications: Chartered Cost Accountant CCA Designation from AAFM
• Business qualifications: Master of Business Administration (MBA),Bachelor of Business Management (BBM), Master of Financial Administration (MFA), Doctor of Business Administration (DBA)
• Finance qualifications: Chartered Financial Analyst (CFA),Certified International Investment Analyst(CIIA), Association of Corporate Treasurers (ACT), Masters degree in Finance, Certified Market Analyst (CMA/FAD) Dual Designation, Master Financial Manager (MFM), Corporate Finance Qualification (CF) Register Financial Planner (RFP), Certified Financial Consultants (CFC)
• Quantitative Finance qualifications: Master of Science in Financial Engineering (MSFE) ,Master of Quantitative Finance (MQF), Master of Computational Finance (MCF), Master of Financial Mathematics (MFM)

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