Finance is the science of
fund management. The general areas of finance are
business finance,
personal
finance, and
public
finance. 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.
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.
The main techniques and sectors of the financial industry
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
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
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
bond. 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 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:
- Beginning Cash Balance - contains the last
period's closing cash balance.
- Cash collections - includes all expected cash
receipts (all sources of cash for the period considered, mainly
sales)
- 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)
- 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.
- Financing - discloses the planned borrowings
and repayments, including interest.
- 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
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
- 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
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
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 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
bond 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' 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
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:
- Empirical studies that demonstrate significant deviations from
classical theories.
- Models of how psychology affects trading and prices
- Forecasting based on these methods.
- 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). 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
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:
See also
References
- Gove, P. et al. 1961. Finance. Webster's Third New
International Dictionary of the English Language Unabridged.
Springfield, Massachusetts: G. & C. Merriam Company.
- finance. (2009). In Encyclopædia Britannica. Retrieved June 23,
2009, from Encyclopædia Britannica Online:
http://www.britannica.com/EBchecked/topic/207147/finance
- Microsoft. 2009. Finance. uk.encarta.msn.com,
http://www.webcitation.org/5hlUjB4mc
External links