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:
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), 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.
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.
Corporate finance
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
Euro Bonds
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
Hardcore debentures
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 downside of Finances
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.
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
Identification of required expenditure of a public sector entity
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